MA 21-38 Replacement of a machine, income taxes sensitivity.

The Smacker Company is a family-owned business that produces fruit jam. The company has a grinding machine that has been in use for three years. On Jan. 1, 2009, Smacker is considering the purchase of a new grinding machine. Smacker has two options:

(1) continue using the old machine or (2) sell the old machine and purchase a new machine. The seller of the new machine isn't offering a trade-in. The following information has been obtained:

Smacker is subject to a 40% income tax rate. Assume that any gain or loss on the sale of machines is treated as an ordinary tax item and will affect the taxes paid by Smacker in the year in which it occurs. Smacker's after-tax required rate of return is 16%. Assume all cash flows occur at year-end except for initial investment amounts.

Questions

1. You have been asked whether Smacker should buy the new machine. To help in your analysis, calculate the following:

1. a) One-time after-tax cash effect of disposing of the old machine on January 1, 2009
2. b) Annual recurring after-tax cash operating savings from using the new machine (variable and fixed)
3. c) Cash tax savings due to differences in annual depreciation of the old machine and the new machine
4. d) Difference in after-tax cash flow from terminal disposal of new machine and old machine

2. Use your calculation in requirement 1 and the net present value method to determine whether Smacker should use the old machine or acquire the new machine.

H8

Selling a plant with income taxes consideration

The Crossroad Company is an international clothing manufacturer. Its Santa Monica plant will become idle on December 31, 2008. Peter Laney, the corporate controller, has been asked to look at three options regarding the plant.

Option 1: The plant, which has been fully depreciated for tax purposes, can be sold immediately for $340,000.

Option 2: The plant can be leased to the Austin Corporation, one of Crossroad's suppliers, for four years. Under the lease terms, Austin would pay Crossroad $96,000 rent per year (payable at year-end) and would grant Crossroad a $18,960 annual discount off the normal price of fabric purchased by Crossroad (assume discount received at year-end for each of the four years). Austin would bear all of the plant's ownership costs. Crossroad expects to sell this plant of $80,000 at the end of four-year lease.

Option 3: The plant could be used for four years to make souvenir jackets for the Olympics. Fixed overhead costs (a cash outflow) before any equipment upgrades are estimated to be $8,000 annually for the four-year period. The jackets are expected to sell for $42 each. Variable cost per unit is expected to be $33. The following production and sales of jackets are expected: 2009, 8,000 units; 2010, 12,000 units; 2011, 16,000 units; 2012, 4,000 units. In order to manufacture the jackets, some of the plant equipment would need to be upgraded at an immediate cost of $60,000. The equipment would be depreciated using the straight-line depreciation method and zero terminal disposal value over the four years it would be in use. Because of the equipment upgrades, Crossroad could sell the plant for $120,000 at the end of four years. No change in working capital would be required.

Crossroad treats all cash flows as if they occur at the end of the year, and it uses an after-tax required rate of return of 12%. Crossroad is subject to a 40% tax rate on all income, including capital gains.

Questions:

1. Calculate net present value of each of the options and determine which option Crossroad should select using the NPV criterion.

2. What non-financial factors should Crossroad consider before