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Since this is a capital budgeting analysis and we are analyzing cash flows, we need to calculate the effect on cash of the asset exchange the way the U.S. income tax authorities require it to be reported on the company’s income tax return. According to the U.S. tax code, in an exchange of like-kind property such as takes place when a seller gives a trade-in allowance for the old equipment, any gain or loss from the disposal of the old asset is deferred until the replacement asset is sold. The basis of the acquired equipment is the same as the basis of the property transferred; and if money was paid, the basis of the acquired equipment is the basis of the transferred property plus the amount of money paid. The machine being replaced and traded in has a cost basis of zero, because it is fully depreciated. Therefore, the depreciable cost basis for the new equipment is zero plus the amount paid after subtracting the trade-in value of the old machine, or 0 + 1,000,000 – 50,000 = $950,000. By reducing the cost basis of the new machine, Verla Industries is effectively deferring reporting of the $50,000 gain on the sale of the old machine until the new machine is sold in a taxable transaction. When the new machine is sold, any gain on the disposal of the new machine will be $50,000 greater than it would be if the depreciable base had been $1,000,000. And if there is a loss on the sale of the new machine, that loss will be $50,000 less. Since the cost basis (depreciable basis for tax purposes) is $950,000, annual straight-line depreciation is $950,000 / 5 = $190,000, and the depreciation tax shield is $190,000 × .40 = $76,000. The annual cash inflow for Years 1 through 5 is $136,000: $60,000 operating cash flow after tax ($100,000 × .60) plus the Depreciation Tax Shield of $76,000. The present value of an annuity factor for 5 years at 10% is 3.791, so the present value of the annual operating cash inflows after tax is $136,000 × 3.791, or $515,576. The net present value is that $515,576 minus the initial cost in Year 0 of $950,000, which is ($434,424). (Note that if the old machine had been sold to a third party for $50,000 in a separate transaction instead of traded in and the new machine bought for $1,000,000, the $50,000 gain on the sale of the old machine would have been taxable, and the depreciable cost basis for the new machine would have been $50,000 greater, or $1,000,000.)
This answer results from two errors: 1. The $50,000 trade-in is included twice in Year 0 — once as a $50,000 cash inflow, and again as a reduction in the amount paid for the equipment, because the amount paid for the equipment is included as $950,000 instead of $1,000,000. 2. The depreciation tax shield is calculated using a depreciable base of $1,000,000. The depreciable base should be $950,000. Please see the correct answer for a discussion of the U.S. tax laws that impact the cash flows from this exchange of assets.
This is not the correct answer. Please see the correct answer for an explanation. We have been unable to determine how to calculate this incorrect answer choice. If you have calculated it, please let us know how you did it so we can create a full explanation of why this answer choice is incorrect. Please send us an email at support@hockinternational.com. Include the full Question ID number and the actual incorrect answer choice -- not its letter, because that can change with every study session created. The Question ID number appears in the upper right corner of the ExamSuccess screen. Thank you in advance for helping us to make your HOCK study materials better.
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