Powell Corporation, a large, diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380,000, and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-year recovery period. The present (old) machine was purchased 3 years ago at a cost of $240,000 and was being depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine and to remove it at the buyer’s expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement; these changes will result in a $17,000 ($35,000 - $18,000) increase in net working capital. Both ordinary income and capital gains are taxed at a rate of 40%. The only component of the initial investment calculation that is difficult to obtain is taxes. Because the firm is planning to sell the present machine for $40,000 more than its initial purchase price, a capital gain of $40,000 will be realized. The book value of the present machine can be found by using the depreciation percentages from Table 3.2 (page 100) of 20%, 32%, and 19% for years 1, 2, and 3, respectively. The resulting book value is $69,600 ($240,000 - [(0.20 +0.32 +0.19) ×$240,000]). An ordinary gain of $170,400 ($240,000[1] $69,600) in recaptured depreciation is also realized on the sale. The total taxes on the gain are $84,160 [($40,000 + $170,400) × 0.40]. Substituting these amounts into the format in Table 8.2 results in an initial investment of $221,160, which represents the net cash outflow required at time zero.

Installed cost of proposed machine	Â	Â
Cost of proposed machine	$380,000	Â
+ Installation costs	20,000	Â
Total installed cost—proposed	Â	Â
(depreciable value)	Â	$400,000
- After-tax proceeds from sale of present machine	Â	Â
Proceeds from sale of present machine	$280,000	Â
- Tax on sale of present machine	84,160	Â
Total after-tax proceeds—present	Â	195,840
+ Change in net working capital	Â	17,000
Initial investment	Â	$ 221,160

 

TABLE 8.2

The Basic Format for Determining Initial Investment

Installed cost of new asset =

Cost of new asset

+ Installation costs

- After-tax proceeds from sale of old asset =

Proceeds from sale of old asset

±Tax on sale of old asset

 Change in net working capital

Initial investment

 

TABLE 3.2
Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes
Â	Percentage by recovery yeara
Recovery year	3 years	5 years	7 years	10 years
1	33%	20%	14%	10%
2	45	32	25	18
3	15	19	18	14
4	7	12	12	12
5	Â	12	9	9
6	Â	5	9	8
7	Â	Â	9	7
8	Â	Â	4	6
9	Â	Â	Â	6
10	Â	Â	Â	6
11	___	___	___	4
Totals	100%	100%	100%	100%