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Tax Losses and Gains in Capital Budgeting

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Hercules Exercising Equipment Co. purchased a computerized measuring device two years ago for $60,000. The equipment falls into the five-year category for MACRS depreciation and can currently be sold for $23,800. A new piece of equipment will cost $150,000. It also falls into the five-year category for MACRS depreciation.

Assume the new equipment would provide the following stream of added cost savings for the next six years {see attachment}.

The firm's tax rate is 34% and the cost of capital is 12%.
a. What is the book value of the old equipment?
b. What is the tax loss on the sale of the old equipment?
c. What is the tax benefit from the sale?
d. What is the cash inflow from the sale of the old equipment?
e. What is the net cost of the new equipment? (Include the inflow from the sale of the old equipment.)
f. Determine the depreciation schedule for the new equipment.
g. Determine the depreciation schedule for the remaining years of the old equipment.
h. Determine the incremental depreciation between the old and new equipment and the related tax shield benefits.
i. Compute the aftertax benefits of the cost savings.
j. Add the depreciation tax shield benefits and the aftertax cost savings and determine the present value.
k. Compare the present value of the incremental benefits (j) to the net cost of the new equipment (e). Should the replacement be undertaken?

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