370 PART 3 Long-Term Investment Decisions
EXAMPLE Powell Corporation, a large, diversified manufacturer of aircraft components, is
trying to determine the initial investment required to replace an old machine with
a new, more sophisticated model. The machine’s purchase price is $380,000, and
an additional $20,000 will be necessary to install it. It will be depreciated under
MACRS using a 5-year recovery period. The present (old) machine was pur-
chased 3 years ago at a cost of $240,000 and was being depreciated under
MACRS using a 5-year recovery period. The firm has found a buyer willing to
pay $280,000 for the present machine and to remove it at the buyer’s expense.
The firm expects that a $35,000 increase in current assets and an $18,000
increase in current liabilities will accompany the replacement; these changes will
result in a $17,000 ($35,000$18,000) increasein net working capital. Both
ordinary income and capital gains are taxed at a rate of 40%.
The only component of the initial investment calculation that is difficult to
obtain is taxes. Because the firm is planning to sell the present machine for
$40,000 more than its initial purchase price, a capital gain of $40,000 will be
realized. The book value of the present machine can be found by using the depre-
ciation percentages from Table 3.2 (page 100) of 20%, 32%, and 19% for years
1, 2, and 3, respectively. The resulting book value is $69,600($240,000
[(0.200.320.19)$240,000]). An ordinary gainof $170,400 ($240,000
$69,600) in recaptured depreciation is also realized on the sale. The total taxes
on the gain are $84,160 [($40,000$170,400)0.40]. Substituting these
amounts into the format in Table 8.2 results in an initial investment of $221,160,
which represents the net cash outflow required at time zero.
Installed cost of proposed machine
Cost of proposed machine $380,000Installation costs (^2) (^0) , (^0) (^0) (^0)
Total installed cost—proposed
(depreciable value) $400,000
After-tax proceeds from sale of present machine
Proceeds from sale of present machine $280,000
Tax on sale of present machine (^8) (^4) , (^1) (^6) (^0)
Total after-tax proceeds—present 195,840
Change in net working capital 17,000
Initial investment $
2
2
1
,
1
6
0
Review Questions
8–9 Explain how each of the following inputs is used to calculate theinitial in-
vestment:(a)cost of new asset,(b)installation costs,(c)proceeds from sale
of old asset,(d)tax on sale of old asset, and(e)change in net working capital.
8–10 How is the book valueof an asset calculated? What are the three key
forms of taxable income?
8–11 What four tax situations may result from the sale of an asset that is being
replaced?
8–12 Referring to the basic format for calculating initial investment, explain
how a firm would determine the depreciable valueof the new asset.