Looner Industries is currently

Looner Industries is currently analyzing the purchase of a newmachine that costs $165,000

and requires $19,800in installation costs. Purchase of thismachine is expected to result in an increase in net working capitalof $30,400to support the expanded level of operations. The firmplans to depreciate the machine under MACRS using a​ 5-yearrecovery period​ (see the table

LOADING…for the applicable depreciation​ percentages) andexpects to sell the machine to net

$10,400 before taxes at the end of its usable life. The firm issubject to a 40 % tax rate.

Rounded Depreciation Percentages by Recovery Year Using MACRSforFirst Four Property Classes
Percentage by recovery year*
Recovery year 3years 5years 7years 10 years
1 33% 20% 14% 10%
2 45% 32% 25% 18%
3 15% 19% 18% 14%
4 7% 12% 12% 12%
5 12% 9% 9%
6 5% 9% 8%
7 9% 7%
8 4% 6%
9 6%
10 6%
11 4%
Totals 100% 100% 100% 100%

a. Calculate the terminal cash flow for a usable life of ​ (1)3​ years, (2) 5​ years, and​ (3) 7 years.

b. Discuss the effect of usable life on terminal cash flowsusing your findings in part a.

assuming a​ 5-year usable​ life, calculate the terminal cashflow if the machine were sold to net​ (1) $9,240

or​ (2) $170,500(before taxes) at the end of 5 years.

d. Discuss the effect of sale price on terminal cash flow usingyour findings in part c.

Answer:

Firstly we will compute the total value of cost of machine asthe cost of machine includes the cost of installation.

cost of New machine $165000
Installation cost $19,800
Total cost ofmachine $184800

Step 1 :part a :Calculate the terminal cash flow for a usable life of ​ (1)3​ years, (2) 5​ years, and​ (3) 7 years

Expected selling price of machine:$10,400(given)

Increase in working capital change :$30,400(given)

Scrap value -nill(assumed)(so ignoring incomputation)

Terminal cash flow : salvage or scrap value +tax savingon loss of asset or ( -) Tax burden on gain on sale of asset+release of working capital.

Particulars 3 years 5 years 7 years
a)selling price $10400 $10400 $10400
b)Book value of machine 184800 184800 184800
c)Cummulative depreciation charged onmachine (144144) (171864) (184800)
d)remaining value(b-c) 40656 12936
e)Profit /loss on sale(a-d) (30256) (2536) 10400
f)tax saving on sale of asset 12,102.4 1014.4
g) tax gain in sale of asset 4160
h)net working capital $30,400 $30,400 $30,400
Terminal value $42502.4 $31414.4 $26240

step 2 : partb:Discuss the effect of usablelife on terminal cash flows using your findings in part a.

From part a we can conclue the terminal value is more in year 3as compared to year 5 when the machine is sold in the less than theremaining book value.

Step 3 :partc:assuming a​ 5-year usable​ life,calculate the terminal cash flow if the machine were sold to net​(1) $9,240or​ (2) $170,500(before taxes) at the end of 5years

Particulars 5 years 7 years
a)selling price $9400 $170500
b)Book value of machine 184800 184800
c)Cummulative depreciation charged onmachine (171864) (184800)
d)remaining value(b-c) 12936
e)Profit /loss on sale(a-d) (3536) 170500
f)tax saving on sale of asset 1414.4
g) tax gain in sale of asset 68200
h)net working capital $30,400 $30,400
Terminal value $31814.4 $(68200)

step 4:partd:Discuss the effect of sale price on terminal cash flowusing your findings in part c.

As a result of high selling price in year 5 i.e 170500the 5th year ‘s terminal value is negative which means as a resultof increase in tax burdern there will be an outflow $68200. whereasthe selling price of year 3 is lessthan the remaining book value asa result there is tax saving and the terminal cash flow ispositive.


 
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