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finNotesCapBudget - CAPITAL BUDGETING The Problem Step 1...

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CAPITAL BUDGETING The Problem Step 1: Computing the Incremental Cash Flows Step 2: Computing the Initial Outlay Step 3: Computing the NPV and IRR The Problem Old equipment: book value = $600,000 with a remaining life of 5 years Expected salvage value in 5 years = 0 Market value today = $265,000 Straight-line depreciation New equipment: purchase price = $1,175,000 and a MACRS life of 5 years Expected salvage value in 5 years = $145,000 Annual savings = $255,000 Other information: 40% marginal tax rate and a 12% hurdle rate Step 1: Incremental Cash Flows CF = ( S - C - D)(1 - t) + D Let's first find D. The depreciation on the old equipment is easy since it's straight-line. D = 600000/5 = 120000 per year. The new machine is being depreciated using MACRS and it's in the 5 year class. Look in the text for a table of the percentages to use each year. For a 5 year asset, the percentages are 20%, 32%, 19%, 12% and 11%. That's a total of 94%. That means the book value at the end of the 5th year is 6%. Remember, with MACRS a 5 year asset really means 5.5 years and the remaining 6% is a half year's depreciation. Applying these rates to the price of 1,175,000 gives the following annual depreciation for the new equipment: .20*1,175,000 = 235,000; .32*1,175,000 = 376,000; .19*1,175,000 = 223,250; . 12*1,175,000 = 141,000; .11*1,175,000 = 129,250 with a remaining book value of .06*1,175,000 = 70,500. Merely subtract the depreciation on the old equipment of $120,000 from the depreciation on the new equipment to get each year's D.
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