Top-Ten Inc. is considering replacing its existing machine that is used to produce musical CDs. This existing machine was purchase 3 years ago at a base price of $60,000. Installation costs at the time for the machine were $1,000. The existing machine is considered a 3-year class for MACRS. The existing machine can be sold today for $40,000 and for $10,000 in 3 years. The new machine has a purchase price of $80,000 and is also considered a 3-year class for MACRS. Installation costs for the new machine are $7,000. The estimated salvage value of the new machine is $20,000. This new machine is more efficient than the existing one and thus savings before taxes using the new machine are $8,000 a year. The company's marginal tax rate is 30% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 1?

$12,943.10

Explanation:

To answer let us begin with knowing the MACRS percentages.

Both machines are considered a 3 year class for MACRS.

3 Year MACRS percentages are as follows,

Year 1= 33.33%

Year 2=44.45%

Year 3=14.81%

Year 4=7.41%

To calculate the Incremental cash flow we would need to subtract the tax on the Pre-tax savings as well as the depreciation tax shield.

DEPRECIATION TAX SHIELD.

Depreciation on New Machine is,

= First year MACRS * purchase price.

= 33.33% * 87,000 ( include installation price)

= $28,997.10

Subtract depreciation on original machine which is now in FOURTH year so we use the 4 year depreciation rate,

= 61,000 * 7.41%

= $4,520.10

Subtracting them would give,

= 28,997.10 - 4,520.10

= $24,477

This is the Additional depreciation.

We need to calculate the tax shield on it.

= 24,477 * 30%

= $7,341.10 is the tax shield.

Now to calculate the Incremental Cash flow.

= Pre-tax Savings - (tax on Pre-tax Savings) + Depreciation tax shield

= 8,000 - (8,000 * 30%) + 7,341.10

= $12,943.10

$12,943.10 is the Incremental Cash flow in year 1.