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Chapter 12: Problem 3

Kennedy Air Services is now in the final year of a project. The equipment originally cost \(\$ 20\) million, of which \(80 \%\) has been depreciated. Kennedy can sell the used equipment today for \(\$ 5\) million, and its tax rate is \(40 \% .\) What is the equipment's after-tax net salvage value?

Short Answer

Expert verified
The after-tax net salvage value is \( \$4.6 \) million.

Step by step solution

01

Determine the Book Value of the Equipment

To find the book value of the equipment, we start with the original cost and account for the depreciation. The equipment originally cost \( \\(20 \) million, and \( 80\% \) of it has been depreciated. So, the depreciated amount is \( 0.80 \times 20 \) million, which equals \( \\)16 \) million. Therefore, the book value is \( 20 - 16 = \$4 \) million.
02

Calculate the Gain/Loss on Sale of Equipment

The gain or loss on the sale of the equipment is calculated by subtracting the book value from the selling price. The selling price of the equipment is \( \\(5 \) million. Using the book value from Step 1 (\( \\)4 \) million), the gain is \( 5 - 4 = \$1 \) million.
03

Determine the Tax on the Gain

We need to calculate the tax on the gain from the sale. With a tax rate of \( 40\% \), the tax is \( 0.40 \times 1 \) million, which is \( \$0.4 \) million.
04

Calculate the After-Tax Net Salvage Value

Subtract the tax calculated in Step 3 from the selling price to find the after-tax net salvage value. The selling price is \( \\(5 \) million, and the tax is \( \\)0.4 \) million. Therefore, the after-tax net salvage value is \( 5 - 0.4 = \$4.6 \) million.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Depreciation
Understanding depreciation is crucial when dealing with the value of assets over time. Depreciation accounts for the reduction in value of an asset due to wear and tear, age, or obsolescence. In the case of Kennedy Air Services, the equipment's original cost was \( \\(20 \) million, but \( 80\% \) of that value has been written off as depreciation. This means \( 0.80 \times 20 = \\)16 \) million has been depreciated, leaving a book value of \( \$4 \) million. Depreciation helps in reflecting the true value of an asset at any given point.
Tax Rate Calculation
Taxes play a significant role in financial planning and asset management. Calculating the tax rate in transactions like the sale of equipment is essential. For Kennedy Air Services, the tax rate applied is \( 40\% \). This tax rate is used to determine the taxes owed on the gain from the sale of equipment. With a gain of \( \\(1 \) million (derived from the sale), the tax amount is \( 0.40 \times 1 = \\)0.4 \) million. Accurate tax rate calculations ensure compliance and help in determining the net benefit gained from sales.
Net Salvage Value
The net salvage value is the amount a company receives from selling an asset, minus any associated taxes or costs. For educational and practical purposes, understanding how to calculate it is essential. Kennedy Air Services sold its equipment for \( \\(5 \) million. After accounting for the \( \\)0.4 \) million in taxes on the gain, the net salvage value comes to \( \$4.6 \) million. This figure is important for companies to evaluate how much cash they can reinvest into their operations after liquidating an asset.
Gain or Loss on Sale
When companies sell assets, understanding whether they incur a gain or a loss is key to financial health. To calculate this, one must subtract the book value of the asset from the sale price. Here, Kennedy Air Services had a book value of \( \\(4 \) million and sold the equipment for \( \\)5 \) million, resulting in a gain of \( \$1 \) million. Recognizing gains or losses influences decision-making and strategy around asset management and future investments.
Book Value Assessment
Book value is the recorded cost of an asset, adjusted for depreciation. It is a fundamental measure used to assess an asset's value after accounting for all depreciation. Kennedy Air Services determined that their equipment, originally costing \( \\(20 \) million, had a book value of \( \\)4 \) million after \( \$16 \) million was written off. Book value helps companies understand the depreciated worth of their assets and aids in determining gains or losses upon sale. Knowing an asset's book value is crucial in making informed financial decisions.

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Most popular questions from this chapter

The Chang Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine is in good working order and will last at least another 10 years. The proposed replacement machine will perform the operation so much more efficiently that Chang's engineers estimate that it will produce after-tax cash flows (labor savings and depreciation) of \(\$ 9,000\) per year. The new machine will cost \(\$ 40,000\) delivered and installed, and its economic life is estimated to be 10 years. It has zero salvage value. The firm's WACC is \(10 \%\), and its marginal tax rate is \(35 \%\). Should Chang buy the new machine? Explain.

Mississippi River Shipyards is considering replacing an 8-year-old riveting machine with a new one that will increase earnings before depreciation from \(\$ 27,000\) to \(\$ 54,000\) per year. The new machine will cost \(\$ 82,500,\) and it will have an estimated life of 8 years and no salvage value. The new machine will be depreciated over its 5 -year MACRS recovery period; so the applicable depreciation rates are \(20 \%, 32 \%\) \(19 \%, 12 \%, 11 \%,\) and \(6 \% .\) The applicable corporate tax rate is \(40 \%,\) and the firm's WACC is \(12 \% .\) The old machine has been fully depreciated and has no salvage value. Should the old riveting machine be replaced by the new one? Explain your answer.

The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of \(\$ 600,000\) and a remaining useful life of 5 years. The firm does not expect to realize any return from scrapping the old machine in 5 years, but it can sell it now to another firm in the industry for \(\$ 265,000\). The old machine is being depreciated by \(\$ 120,000\) per year using the straight-line method. The new machine has a purchase price of \(\$ 1,175,000,\) an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of \(\$ 145,000\). The applicable depreciation rates are \(20 \%, 32 \%, 19 \%, 12 \%, 11 \%\), and \(6 \% .\) The machine is expected to economize on electric power usage, labor, and repair costs as well as to reduce the number of defective bottles. In total, an annual savings of \(\$ 255,000\) will be realized if the new machine is installed. The company's marginal tax rate is \(35 \%\), and it has a \(12 \%\) WACC. a. What initial cash outlay is required for the new machine? b. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. c. What are the incremental net cash flows in Years 1 through 5? d. Should the firm purchase the new machine? Support your answer. e. In general, how would each of the following factors affect the investment decision, and how should each be treated? (1) The expected life of the existing machine decreases. (2) The WACC is not constant but is increasing as Bigbee adds more projects to its capital budget for the year.

A firm has two mutually exclusive investment projects to evaluate; both can be repeated indefinitely. The projects have the following cash flows: Projects \(X\) and \(Y\) are equally risky and may be repeated indefinitely. If the firm's WACC is \(12 \%,\) what is the EAA of the project that adds the most value to the firm? (Round your final answer to the nearest whole dollar.)

The Fernandez Company has an opportunity to invest in one of two mutually exclusive machines that will produce a product the company will need for the next 8 years. Machine \(A\) costs \(\$ 10\) million but will provide after-tax inflows of \(\$ 4\) million per year for 4 years. If Machine \(A\) was replaced, its cost would be \(\$ 12\) million due to inflation and its cash inflows would increase to \(\$ 4.2\) million due to production efficiencies. Machine B costs \(\$ 15\) million and will provide after-tax inflows of \(\$ 3.5\) million per year for 8 years. If the \(\mathrm{WACC}\) is \(10 \%,\) which machine should be acquired? Explain.
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