(30) I am considering replacing an old steel cutting machine with a
new one. Two months ago, I sent the company engineer to a training
seminar demonstrating the new machine's operation and efficiency.  The
$2,500 cost for this training session has already been paid. If the
new machine is purchased, it would require $5,000 in installation and
modification costs to make it suitable for operation.  The old machine
originally cost $50,000 five years ago and is being depreciated by
$7,000 per year. The new machine will cost $75,000 before installation
and modification.  It will be depreciated by $5,000 per year.  The old
machine can be sold today for $10,000.  The marginal tax rate for the
firm is 40%.  Compute the relevant initial outlay in this capital
budgeting decision.

a)$72,500
b)68,000
c)70,500
d)78,000

Hi again k9queen!!!

I will start listing the costs:

Training = $2,500
Installation = $5,000
New Machine cost = $75,000
Income from sale of the old machine = $10,000
Old machine sale Taxes = $0.00

Here a clarification is needed:
The Old Machine original cost was $50,000, and it was depreciating by
$7,000 per year during five years; then the total depreciation is
$35,000 and in consecuence the residual value is $15,000.
If you sell the old machine for $10,000 you are receiving for this
less money than the residual value, then there isnīt profits for this
operation and no taxes are applicable. To deduce taxes you have to
receive more than the residual value, in this case $15,000 (next year
will be $8,000 and if you receive $10,000 taxes will be paid).

The relevant initial outlay in this capital budgeting decision is:

New Machine cost + Installation cost + Training cost - Old Machine
sale value =

= $75,000 + $5,000 + $2,500 - $10,000 = $72,500

The correct answer is a).

Hope this helps. 
Remember if you need a clarification post a request for it.

Best regards.
livioflores-ga

---

Clarification of Answer by livioflores-ga on 11 Feb 2003 08:21 PST

Dear k9queen!!

After researching for solve other of your problems I found more
information about the Salvage Value of old machines.

After Tax Salvage Value:
The after tax salvage value involves calculating the tax on the sale
of the asset and subtracting it from the salvage value (market value
of the asset when it is sold).

After Tax Salvage Value = ATSV
Salvage Value = SV
Book Value = BV
Accumulated Depreciation = Dt

ASTV = SV - Tax on the Salvage Value =
     = SV - [(Taxable Basis) * (Tax Rate)] =
     = SV - [(SV - BV)* (Tax Rate)] =
     = SV-[(SV -(Original Value-Dt))*(Tax Rate)]

When the Book Value of the Asset is 0, the salvage value simplifies to
the following:

ATSV = SV - [(SV *(Tax Rate)] = SV *(1-T) .

In the answer that I provided to you ATSV must replace the term "Old
Machine
sale value".

Then the relevant initial outlay in this capital budgeting decision
is:

I = New Machine cost + Installation cost + Training cost - ATSV 

The Book Value for the old machine is 
BV = $50,000 - $7,000 * 5 = $15,000

ATSV = SV-[(SV - BV)*(Tax Rate)] =
     = $10,000 - ($10,000 - $15,000) * 0.40 = $10,000 - (-$2,000) =
     = $12,000 .

Then 
I = $75,000 + $5,000 + $2,500 - $12,000 = $70,500 .

So the correct answer is c).

----------------------------------------

For a better clarification of this new concept I will provide you a
little example:
Old Machine Book value = $15,000, Tax Rate = 34% . 
Estimate the Taxes for the following Salvage Values:
a)$35,000; b)$25,000; c)$15,000; d)$12,000

 a). Tax payments associated with the sale for $35,000:

      Recapture of depreciation = ($35,000-$15,000)*(0.34) = $6,800


 b). Tax payments associated with sale for $25,000:

      Recapture of depreciation = ($25,000-$15,000)*(0.34) = $3,400


 c). No taxes, because the machine would have been sold for its book
value.


 d). Tax savings from sale below book value:

      Tax savings = ($15,000-$12,000)*(0.34)  = $1,020


When you calculate the Terminal Cash Flow for an old machine you must
compute the Salvage Value plus Recapture of depreciation if Salvage
Value is greater than Book Value, or you must compute the Salvage
Value less Tax savings if Book value is greater than Salvage value.
The introduction of the ATSV concept in the Initial Investment formula
do this directly.

I hope this clarify the resolution of the problem.
Please, ask for a clarification if it needed.

Best Regards.
livioflores-ga

Very clear and easy to understand! And speedy!