Powell Corporation, a large, diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380,000, and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-year recovery period. The present (old) machine was purchased 3 years ago at a cost of $240,000 and was being depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine and to remove it at the buyer’s expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement; these changes will result in a $17,000 ($35,000 - $18,000) increase in net working capital. Both ordinary income and capital gains are taxed at a rate of 40%. The only component of the initial investment calculation that is difficult to obtain is taxes. Because the firm is planning to sell the present machine for $40,000 more than its initial purchase price, a capital gain of $40,000 will be realized. The book value of the present machine can be found by using the depreciation percentages from Table 3.2 (page 100) of 20%, 32%, and 19% for years 1, 2, and 3, respectively. The resulting book value is $69,600 ($240,000 - [(0.20 +0.32 +0.19) ×$240,000]). An ordinary gain of $170,400 ($240,000[1] $69,600) in recaptured depreciation is also realized on the sale. The total taxes on the gain are $84,160 [($40,000 + $170,400) × 0.40]. Substituting these amounts into the format in Table 8.2 results in an initial investment of $221,160, which represents the net cash outflow required at time zero.

Installed cost of proposed machine
Cost of proposed machine	$380,000
+ Installation costs	20,000
Total installed cost—proposed
(depreciable value)		$400,000
- After-tax proceeds from sale of present machine
Proceeds from sale of present machine	$280,000
- Tax on sale of present machine	84,160
Total after-tax proceeds—present		195,840
+ Change in net working capital		17,000
Initial investment		$ 221,160

 

TABLE 8.2

The Basic Format
for Determining
Initial Investment

Installed cost of new asset =

Cost of new asset

+ Installation costs

- After-tax proceeds from sale of old asset =

Proceeds from sale of old asset

±Tax on sale of old asset

 Change in net working capital

Initial investment

 

TABLE 3.2
Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes
	Percentage by recovery yeara
Recovery year	3 years	5 years	7 years	10 years
1	33%	20%	14%	10%
2	45	32	25	18
3	15	19	18	14
4	7	12	12	12
5		12	9	9
6		5	9	8
7			9	7
8			4	6
9				6
10				6
11	___	___	___	4
Totals	100%	100%	100%	100%