Actual Investment Decision
Assume in the $50,000 depreciation analysis shown in Table 12-13 that we are given additional facts and asked to make an investment decision about whether an asset should be purchased or not. We shall assume we are purchasing a piece of machinery that will have a six-year productive life. It will produce income of $18,500 for the first three years before deductions for depreciation and taxes. In the last three years, the income before depreciation and taxes will be $12,000. Furthermore, we will assume a corporate tax rate of 35 percent and a cost of capital of 10 percent for the analysis. The annual cash flow related to the machinery is presented in Table 12-14. For each year we subtract depreciation from “earnings before depreciation and taxes” to arrive at earnings before taxes. We then subtract the taxes to determine earnings after taxes. Finally, depreciation is added to earnings after taxes to arrive at cash flow. The cash flow starts at $15,525 in the first year and ends at $8,815 in the last year.
Table 12-14 Cash flow related to the purchase of machinery
Having determined the annual cash flows, we now are in a position to discount the values back to the present at the previously specified cost of capital, 10 percent. The analysis is presented in Table 12-15. At the bottom of the same table, the present value of the inflows is compared to the present value of the outflows (simply the cost of the asset) to arrive at a net present value of $7,991. On the basis of the analysis, it appears that the asset should be purchased.
Table 12-15 Net present value
The Replacement Decision
So far our analysis has centered on an investment that is being considered as a net addition to the present plant and equipment. However, many investment decisions occur because of new technology, and these are considered replacement decisions. The financial manager often needs to determine whether a new machine with advanced technology can do the job better than the machine being used at present.
These replacement decisions include several additions to the basic investment situation. For example, we need to include the sale of the old machine in our analysis. This sale will produce a cash inflow that partially offsets the purchase price of the new machine. In addition, the sale of the old machine will usually have tax consequences. Some of the cash inflow from the sale will be taxable if the old machine is sold for more than book value. If it is sold for less than book value, this will be considered a loss and will provide a tax benefit.
The replacement decision can be analyzed by using a total analysis of both the old and new machines or by using an incremental analysis that emphasizes the changes in cash flows between the old and the new machines. We will emphasize the incremental approach.
Assume the Bradley Corporation purchased a computer two years ago for $120,000. The asset is being depreciated under the five-year MACRS schedule previously shown in Table 12-12, which implies a six-year write-off because of the half-year convention. We will assume the old computer can be sold for $37,600. A new computer will cost $180,000 and will also be written off using the five-year MACRS schedule in Table 12-12.
The new computer will provide cost savings and operating benefits, compared to the old computer, of $42,000 per year for the next six years. These cost savings and operating benefits are the equivalent of increased earnings before depreciation and taxes. The firm has a 35 percent tax rate and a 10 percent cost of capital. First we need to determine the net cost of the new computer. We will take the purchase price of the new computer ($180,000) and subtract the cash inflow from the sale of the old computer.
Sale of Old Asset
The cash inflow from the sale of the old computer is based on the sales price as well as the related tax factors. To determine these tax factors, we first compute the book value of the old computer and compare this figure to the sales price to determine if there is a taxable gain or loss. The book value of the old computer is shown in Table 12-16.
Table 12-16 Book value of old computer
Since the book value of the old computer is $57,600 and the sales price (previously given) is $37,600, there will be a $20,000 loss.
|Tax loss on sale||$20,000|
This loss can be written off against other income for the corporation.4 The Bradley Corporation has a 35 percent tax rate, so the tax write-off is worth $7,000.
|Tax loss on sale||$20,000|
|Tax benefit||$ 7,000|
We now add the tax benefit to the sale price to arrive at the cash inflow from the sale of the old computer.
|Sale price of old computer||$37,600|
|Tax benefit from sale||7,000|
|Cash inflow from sale of old computer||$44,600|
The computation of the cash inflow figure from the old computer allows us to compute the net cost of the new computer. The purchase price of $180,000, minus the cash inflow from the sale of the old computer, provides a value of $135,400 as indicated in Table 12-17.
Table 12-17 Net cost of new computer
|Price of new computer||$180,000|
|− Cash flow from sale of old computer||44,600|
|Net cost of new computer||$135,400|
The question then becomes this: Are the incremental gains from the new computer compared to those of the old computer large enough to justify the net cost of $135,400? We will assume that both will be operative over the next six years, although the old computer will run out of depreciation in four more years. We will base our cash flow analysis on (a) the incremental gain in depreciation and the related tax shield benefits and (b) cost savings.
The annual depreciation on the new computer will be:
The annual depreciation on the old computer for the remaining four years would be:
In Table 12-18, we bring together the depreciation on the old and new computers to determine incremental depreciation and the related tax shield benefits. Since depreciation shields other income from being taxed, the benefits of the tax shield are worth the amount being depreciated times the tax rate. For example, in year 1, $12,960 (third column below) in incremental depreciation will keep $12,960 from being taxed, and with the firm in a 35 percent tax bracket, this represents a tax savings of $4,536. The same type of analysis applies to each subsequent year.
Table 12-18 Analysis of incremental depreciation benefits