Morage Corp. is replacing an entire baking line that was purchased for $420,000 and currently has a book value of $60,000. The new, more efficient line, will cost $940,000 installed and can be depreciated as a 7-year MACRS asset. With the increased efficiency, Morage expects annual revenues to increase by $425,000, and operating expenses to increase by $170,000. The older machine, which was being depreciated at the straight-line rate of $20,000/year, will be sold for $30,000. What are the net cash flows for year 2? Assume the firm's marginal tax rate is 40% and that the year 2 depreciation rate is 24.49% under MACRS.

A) $26,996
B) $332,206
C) $237,082
D) $383,206

Question

Aditya Sagar · Accepted Answer

Final Answer : C, Explanation :  To compute the net cash flows for year 2, we need to calculate the following:1. Depreciation expense on the new machine for year 2:Year 2 depreciation rate for 7-year MACRS property = 24.49%Depreciation expense for year 2 = $940,000 x 24.49% = $230,7562. Depreciation expense on the old machine for year 2:Depreciation expense for year 2 = $20,000 (straight-line rate)3. Gain/loss on sale of old machine:Book value of old machine = $60,000 - ($20,000 x 2 years) = $20,000Gain/loss on sale of old machine = $30,000 - $20,000 = $10,000 (taxable since it's a gain)4. Incremental operating cash flows:Incremental revenues = $425,000Incremental expenses = $170,000Incremental operating cash flows = $425,000 - $170,000 = $255,0005. Tax savings due to depreciation:Tax savings = (New depreciation expense - Old depreciation expense) x Tax rateTax savings = ($230,756 - $20,000) x 40% = $84,302.40Net cash flows for year 2 = Incremental operating cash flows - Tax on gain + Tax savings + New depreciation expense - Old depreciation expenseNet cash flows for year 2 = $255,000 - ($10,000 x 40%) + $84,302.40 + $230,756 - $20,000Net cash flows for year 2 = $237,082.40Therefore, the best choice is C: $237,082.

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