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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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The solution answers questions on Tax Losses and Gains in Capital Budgeting.

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Calculate NPV, IRR for project; evaluate a capital budgeting

1. Given the following information, calculate the NPV and IRR and give your recommendation on the project (accept/reject).

- Cost of automation system (invoice): $750,000
- Transportation and installation: $150,000
- Training: $100,000
- Firm's WACC: 10%
- Firm's tax rate: 40%
- Capital gains tax: 28%
- Depreciation 5 years, straight line.
- Life of project: 3 years
- Salvage value: $375,000
- Annual cost savings (net operating expenses): $100,000
- Increased annual sales (net operating expenses): $200,000

2. Comprehensive Capital Budgeting Problem

You are asked to evaluate a new product line to replace an existing product that is at the end of its product life cycle. From talking with the engineering, marketing and tax departments, the vendors and banks, you arrive at the following assumptions:

- The new product line will replace the existing product line. Lost revenues from replacing the existing product line are expected to be $1,500,000 in YR 1. The existing product was to be discontinued after YR 1.
- The combined Federal and State tax rate is 38.5%.
- The machinery invoice is $25,000,000, including transportation and installation.
- Depreciation on the machinery is 20 years. Use straight line.
- The total market for the product is $350,000,000 (Yr. 1), and expected to grow at a 10% annual rate over the next five years.
- Your company anticipates gaining an average 1% of the total market share the first year, 5% of the total market share the second year and 8% of the total market share the third year. After year three the line will be salvaged and a new facility is planned to incorporate economies of scale.
- Administrative and operating expenses are estimated to be 40% of annual gross revenues.
- The firm's WACC is 10.3%
- The salvage value at the end of three years is estimated to be $22,500,000.
- Any losses can be used against other gains in the company for tax purposes.

Find the NPV, the IRR, and give your recommendation

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