Page 178 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 2. The new machine will cost 2,20,000. It will cost 20,000 for transportation and installation
of machine. The firm will receive 15,000 investment tax credit as a result of the purchases
and installation of the machine.
3. The new machine will have a service life of 4 years. The existing machine will also be able
to produce goods for four more years.

4. The new machine processes raw materials more quickly and works more efficiently on
long production runs. Thus, the firm must tie up an additional 20,000 of goods in
inventories to support the new machine.
5. At the present time, the book value of the existing machine is 80,000 and it is being
depreciated at 20,000 per year, to a zero book value. If the existing machine is sold today,
its cash value would be 40,000. If it continues to operate for 4 more years, its cash value
would be 10,000.
6. The new machine will be depreciated using straight-line depreciation. In four years, it
will have 40,000 book value and 30,000 cash salvage value. Take Income Tax @ 50%.
Step 1 – Calculate the Net Cash Outlay: The net cash outlay is the different amount of money
that will be spent when the investment is made in year zero. It may be calculated by = Total cost
of new investment including purchase price, transportation, installation and any related charges.
Tax savings from investment tax credit +/– changes in the working capital requirements net
cash received from replacing existing machines (i.e., selling price or money received less any
costs of removing the asset) +/– either the taxes saved or additional taxes to be paid as a result
of purchasing the new asset. In our example, 2,20,000 is the purchase price plus 20,000 for
transportation and installation.
The investment tax credit produces a tax saving of 15,000. The working capital tied up is
20,000 that is treated as an outlay in year zero. It will be an inflow in year 4. The cash for the
existing machine is 40,000. The tax effect is a saving that occurs because the firm sells a
6,80,000 book value machine for 40,000, procuring non-cash or book loss. At a 50 per cent tax
rate, the loss of 40, 000 in the sale produces a 20,000 tax savings. Thus, net cash outlay (outflow)
is

2,20,000 + 20,000 – 15,000 + 20,000 – 40,000 – 20,000 = 1,85,000.
Step 2 – Calculate the Depreciation Schedules: In practice, we use the method employed by the
firm for tax purposes since only this method affects the tax shield and cash flow using straight
line depreciation. In our example, the depreciation can be calculated with two formulas as
follows:
Depreciable Cost = Total Cost of machine – Book salvage value
2,40,000 – 40,000 = 2,00,000

Annual Depreciation = Depreciable Cost/Years of life
= 2,00,000/4 = 50,000
With the straight-line method, 50,000 depreciation is the same for each of the four years of the
new machines estimated service life. With other methods, the amount of depreciation differs
each year.
The depreciation on the existing machine is given at 20,000 per year down to zero book value.
Since the current book value is 80,000, the annual depreciation of 20,000 will be realised for
the remaining four years of service life.

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