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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 sellingthe “old” machines. This loss and concomitant tax benefit are shown below: Purchase price$1,250,000Proceeds from sale of recently purchased machines ($1,000 250)250,000Loss$1,000,000Tax Rate.25Tax Savings$250,000The 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 anadditional 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 – 2eFOR INSTRUCTOR USE ONLY6-37
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$250,000Profit from increased wagering on better machines$30,000 250 .10 21,500,000Tax on profit from increased wageringPrevious 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%343,750Net tax benefit lost if old machines are soldComputed in part b(62,500)Increased Profit (Value of machine)$281,250The 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 machineNot knownWTax on profit from wagers in old machine W× 25%(0.25W)Tax shield because of depreciation of old machines $1,250,000× 0.25312,500Profit if we keep old machines $312,500+ 0.75 WNext, we compute the profit if the casino purchases the new machines.Proceeds from sale of recently purchased machines$1,000 250$250,000Tax shield because of loss due to sale($5,000-$1,000) ×250 × 0.25250,000Balakrishnan, Sivaramakrishnan, & Sprinkle – 2eFOR INSTRUCTOR USE ONLY6-38
Profit from wagering on better machinesW+ ($30,000 250.10 2)W+ $1,500,000Tax on profit from wageringPrevious row ×25%(0.25W+ $375,000)Tax shield because of depreciation of new machines$5,500 × 250 ×25%$343,750Cost of better machines$5,500 250($1,375,000)