Spend a few minutes reviewing the difference between a cash outflow and an

# Spend a few minutes reviewing the difference between

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(Spend a few minutes reviewing the difference between a cash outflow and an expense.) Given the data for the Diamond Jubilee, keeping the existing machines produces an overall tax benefit of 0.25 × \$1,250,000 = \$312,500. Now, consider the option of buying the new machines. The acquisition cost of the old machines affects taxes paid in this case as well. If the better video machines are purchased, the Diamond Jubilee will reap a tax benefit from the loss on selling the “old” machines. This loss and concomitant tax benefit are shown below: Purchase price \$1,250,000 Proceeds from sale of recently purchased machines (\$1,000 250) 250,000 Loss \$1,000,000 Tax Rate .25 Tax Savings \$250,000 The important points to notice are that the tax in either case depends on the purchase price of the old machine and that the tax benefit is different across options. That is, the tax effect is not a wash. Keeping the old machines yields an additional tax savings of \$62,500 = \$312,500 - \$250,000. The acquisition cost, while sunk, clearly “matters” in a world with taxes because it leads to differential cash flows between the options. c. Above and beyond our calculations in part [b], there are two other tax effects we need to consider when we compute the profit impact of replacing the old Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY 6-37
machines: (1) The taxes on profit from wagering, and (2) the tax shield due to the depreciation on the new machine. Proceeds from sale of recently purchased machines \$1,000 250 \$250,000 Profit from increased wagering on better machines \$30,000 250 .10 2 1,500,000 Tax on profit from increased wagering Previous row × 0.25 (375,000) Cost of better machines \$5,500 250 (1,375,000) Tax benefit due to depreciation on new machine \$5,500 × 250 × 25% 343,750 Net tax benefit lost if old machines are sold Computed in part b (62,500) Increased Profit (Value of machine) \$281,250 The casino would gain \$281,250 over the two years by replacing the recently acquired video poker machines with the better model. The above table presented the incremental approach for buying the new machines, with status quo as the benchmark (i.e., performed controllable cost analysis). For completeness, we present the gross approach. First, we compute the profit if we keep the old machines. (Note: Because we do not know the wagers over the two years associated with the recently acquired “old” machines, let us call it W . This term “washes” out because it is common to both options.) Wagers on old machine Not known W Tax on profit from wagers in old machine W × 25% (0.25 W ) Tax shield because of depreciation of old machines \$1,250,000× 0.25 312,500 Profit if we keep old machines \$312,500+ 0.75 W Next, we compute the profit if the casino purchases the new machines. Proceeds from sale of recently purchased machines \$1,000 250 \$250,000 Tax shield because of loss due to sale (\$5,000-\$1,000) × 250 × 0.25 250,000 Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY 6-38
Profit from wagering on better machines W + (\$30,000 250 .10 2) W + \$1,500,000 Tax on profit from wagering Previous row × 25% (0.25 W + \$375,000) Tax shield because of depreciation of new machines \$5,500 × 250 × 25% \$343,750 Cost of better machines \$5,500 250 (\$1,375,000)