Question

Miller Corporation is considering replacing a machine. The replacement will reduce operating expenses (that is, increase earnings before depreciation, interest, and taxes) by $16,000 per year for each of the 5 years the new machine is expected to last. Although the old machine has zero book value, it can be used for 5 more years. The depreciable value of the new machine is $48,000. The firm will depreciate the machine under MACRS using a 5-year recovery period and is subject to a 40% tax rate. Estimate the incremental operating cash inflows generated by the replacement.

Answer 1

Answer:

The asset replacement will generate $9,600 yearly incremental operating cash inflows, and total $48,000 incremental operating cash inflows for 5 years.

Explanation:

Since depreciation is not a cash payment but just an estimate of the wear and tear in the value of the machine, it will not be included in the calculation as the profit of $16,000 reported is before deducting depreciation.

The incremental operating cash inflows generated by the replacement can therefore be calculated by deducting tax payment per year from the operating as follows:

Yearly incremental operating cash inflows = Yearly operating earning - tax

                                                                       = $16,000 - ($16,000 × 40%)

                                                                       = $16,000 - $6,400

Yearly incremental operating cash inflows = $9,600

Total incremental operating cash inflows for 5 years = $9,600 × 5 = $48,000

Therefore, the asset replacement will generate $9,600 yearly incremental operating cash inflows, and total $48,000 incremental operating cash inflows for 5 years.

Answer 2

Answer:

tax shield

Year 1:  3840

Year 2: 6144

Year 3: 3864.4

Year 4: 2211.84

Year 5: 2211.84

Year 6: 110.59

Explanation:

we solve for MACRS

$\left[\begin{array}{ccccc}Year&MACR&dep-exp&tax-shield\\1&0.2&9600&3840\\2&0.32&15360&6144\\3&0.192&9216&3686.4\\4&0.1152&5529.6&2211.84\\5&0.1152&5529.6&2211.84\\6&0.00576&276.48&110.592\\Total&&&18204.672\\\end{array}\right]$

The tax shield will be the tax-shield will be the incremental cashflow form the company as this decrease in the income tax payable increase the cash available for the firm