Capital Budgeting with Taxes Considerations

A company owns a packaging machine which was purchased three years ago for $56,000. It has a remaining useful life of five years, providing that it has a major overhaul at the end of two more years of life at a cost of $10,000, fully deductible in that year for income tax purposes. Its cash disposal value now is $20,000; in five years, its cash disposal value will be $8,000. The cash operating costs are expected to be $40,000 annually if the company continues to operate the machine. The company has used a zero salvage value in allocating depreciation for tax reporting purposes. Accumulated straight line depreciation is $21,000.

A manufacturer has offered a substitute machine for $51,000 in cash. The new machine will reduce annual cash operating costs by $10,000, will not require any overhauls, will have a useful life of five years, and will have cash disposal value of $3,000 in five years. Under current tax laws, the company would use sum-of-the-years-digits depreciation for this new machine with no provision for salvage value. Assume a 14% rate of return and a 40% income tax rate.

The company expects to generate $100,000 cash operating revenues in each of the next five years.

Additional assumptions:

1. Operating revenues are subject to 40% tax rate.

2. Operating costs (including both cash and non-cash expenses) are deductible for income tax purposes.

3. Any gain or loss on the disposal of machinery will affect income taxes.

4. All cash inflows and outflows occur at the end of the year.

5. All income tax flows occur at the same time as the related pretax cash flows. Should the new machine be purchased?