Question

Rockyford Company must replace some machinery that has zero book value and a current market value of $3,000. One possibility is to invest in new machinery costing $52,000. This new machinery would produce estimated annual pretax cash operating savings of $20,800. Assume the new machine will have a useful life of 4 years and depreciation of $13,000 each year for book and tax purposes. It will have no salvage value at the end of 4 years. The investment in this new machinery would require an additional $4,200 investment of net working capital. (Assume that when the old machine was purchased, the incremental net working capital required at the time was $0.) If Rockyford accepts this investment proposal, the disposal of the old machinery and the investment in the new one will occur on December 31 of this year. The cash flows from the investment are expected to occur over a four-year period. Rockyford is subject to a 40% income tax rate for all ordinary income and capital gains and has a 8% weighted-average after-tax cost of capital. All operating and tax cash flows are assumed to occur at year-end. (For Parts 2 and 3, use the relevant table from Appendix C-Table 1 or Table 2) Required: 1. Determine the after-tax cash flow arising from disposing of the old machinery. 2. Determine the present value of the after-tax cash flows for the next 4-years attributable to the cash operating savings. 3. Determine the present value of the tax shield effect of depreciation for year 1. 4. Which one of the following is the proper treatment for the additional $4,200 of net working capital required in the current year?​

Answer 1

Step-by-step explanation:

1. The after-tax cash flow arising from disposing of the old machinery is equal to the market value of the old machinery minus the taxes owed on the gain from the sale. Since the old machinery has a zero book value, the entire $3,000 received from the sale is a taxable gain. The taxes owed are equal to 40% of the gain:

$3,000 - ($3,000 x 0.40) = $1,800

Therefore, the after-tax cash flow from disposing of the old machinery is $1,800.

2. The present value of the after-tax cash flows for the next 4 years attributable to the cash operating savings can be calculated using the following formula:

PV = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2) + (CF3 / (1 + r)^3) + (CF4 / (1 + r)^4)

where PV is the present value, CF is the cash flow, r is the discount rate, and the subscripts 1 to 4 denote the year of the cash flow.

In this case, the cash operating savings each year is $20,800. Using a discount rate of 8%, we can calculate the present value of the cash flows:

PV = ($20,800 / (1 + 0.08)^1) + ($20,800 / (1 + 0.08)^2) + ($20,800 / (1 + 0.08)^3) + ($20,800 / (1 + 0.08)^4)

PV = $74,888.47

Therefore, the present value of the after-tax cash flows for the next 4 years attributable to the cash operating savings is $74,888.47.

3. The tax shield effect of depreciation for year 1 can be calculated as follows:

Tax shield effect = Depreciation x Tax rate

Since the depreciation for year 1 is $13,000 and the tax rate is 40%, we have:

Tax shield effect = $13,000 x 0.40

Tax shield effect = $5,200

Therefore, the present value of the tax shield effect of depreciation

Answer 2

The student's questions focus on the cash flow and present value analysis of replacing machinery, which involves calculating after-tax cash flows from disposal, present value of operating savings, and the impact of depreciation tax shields.

Step-by-step explanation:

The student is asking several questions related to the financial decision-making process that involves calculating the cash flows and present values associated with replacing old machinery with new machinery. When a company faces such investment decisions, they often use methods like calculating after-tax cash flows from disposal, present value of cash savings, and tax shield effects to analyze the profitability of the investment.

• Determine the after-tax cash flow arising from disposing of the old machinery: To calculate this, we would subtract any taxes owed on the sale from the market value of the old machinery.
• Determine the present value of the after-tax cash flows for the next 4-years attributable to the cash operating savings: This involves discounting the annual cash savings by the company's weighted-average after-tax cost of capital.
• Determine the present value of the tax shield effect of depreciation for year 1: This would involve calculating the tax savings from depreciation and discounting it back to its present value.
• The proper treatment for the additional $4,200 of net working capital required in the current year: This amount is considered an investment and its treatment will vary depending on the specifics of the financial analysis being conducted.