The current machine, which is being considered for replacement, was purchased on January 1, 2013, for $120,000

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Question:

The current machine, which is being considered for replacement, was purchased on January 1, 2013, for $120,000 with an estimated useful life of 12 years and zero salvage value for financial reporting purposes.3 The estimated disposal value of this machine on January 1, 2015, is $36,000. If not disposed of (i.e., if not sold outright), it is estimated that the current machine could be used for another 10 years (i.e., the same total number of years as its original estimated useful life).

The base purchase price for the replacement machine
is $170,000.4 Delivery cost for the machine, to be born separately by XYZ, is estimated as $5,000. Installation
and testing costs for the new machine are estimated to
be $25,000. In the past, XYZ has “charged” each major investment project with an administrative fee equal to 10% of the purchase price of the asset (investment). This imputed fee represents an allocation of corporate headquarters’ (i.e., “overhead”) expense.

During the discussion of the proposed investment, Watson pointed out that if the company purchases the replacement machine, it is likely to lose some business during the time the old machine is being removed and the replacement machine is installed (and tested). His best guess—and it is only a guess—is that the contribution margin lost during this time would be $5,000 (pre-tax).5

If the replacement asset is purchased, pre-tax operating cash flows are expected to increase by $35,000 per year.6
The new machine is technologically advanced, which is expected to provide two benefits: (1) a reduction in annual cash operating expenses and (2) an increase in sales volume. The latter is attributable to the greater output capacity of the replacement machine. The new machine has an expected useful life of 10 years.

At the end of the following week, the team reconvened to discuss three tax-related issues that arose from their informal conversations during the week: (1) the issue of “like-kind exchanges,” (2) the possibility of taking an accelerated write- off, and (3) the possible use of a “STARKER escrow” for the sale of the existing machine (if the decision were made to replace that machine).

Smith began the meeting by saying: “Well, we’ve covered
a lot of ground here so far, but I wonder whether we’re missing something important from a tax standpoint. For example, our baseline DCF analysis assumes that we’re going to sell the existing asset outright in the open market. In fact, we have a firm offer from a reputable buyer for the existing machine. But I wonder: (1) Would there be any tax advantage to trading in (rather than selling outright) the old asset, under the assumption that the trade-in amount would be equal to, say, the agreed- upon external sales price, $36,000? (2) If we were to negotiate
a trade-in value, what would the breakeven value be? That is, can we come up with the trade-in value that would make us indifferent between keeping and replacing the existing asset? To make the analysis tractable, let’s assume data associated with our base-case scenario and the use of NPV analysis to address this question.” Chang agreed that Smith’s point was interesting and worth exploring. She pointed out that the relevant tax law pertaining to this issue is covered in IRC §1031, “Exchange of property held for productive use or investment.”

Smith continued, “I also recall that two years ago,
when we purchased the existing machine, we talked about expensing the machine immediately, under (I think) IRC §179. I don’t remember the details, but I do remember someone making the point that this election could have saved us more than a trifling amount in terms of our tax
bill. I really can’t remember why we chose not to go that route. Chang, in your opinion, is this option available this year? Would it benefit us? Why or why not? I think we need to address these questions as we evaluate the present investment opportunity.” Chang replied, “I remember an article from a couple of years ago that dealt with these very issues.10 I’ll retrieve and reread it—it may be relevant to the present decision analysis.”

Chang continued, “Speaking of additional tax-related issues, I recently read something—in the Bozeman Daily Chronicle of all places!—that might apply to our situation: using a so-called STARKER escrow in conjunction with a possible disposal of our existing asset. I never heard of such a thing, but I’m intrigued about this possible tax-related option. I wonder whether this STARKER thing would apply to our situation.”

3. Additional Tax-Related Issues:

a. Like-kind exchanges, IRC §1031: Prepare a response with supporting calculations (if appropriate) to the two taxrelated questions raised by Smith in conjunction with the possibility of trading in rather than selling the existing machine outright (if the new machine were purchased): (1) Would there be any tax advantage to trading in (rather than selling) the old asset? (2) What would the breakeven value of the trade in be? Note: When responding to Smith’s second question, assume base-case data. For purposes of responding to this question, you can ignore the incremental investment in net working capital (if any) that would be required if the new asset is purchased.

b. Applicability of IRC §179: Prepare a response, with appropriate authoritative support, to the two questions raised by Smith regarding the provisions of IRC §179, as it pertains to expensing of the cost of the replacement asset: Does XYZ have this option? What are the benefits of this option (if any)?

c. Use of a STARKER escrow in conjunction with the disposal of the existing asset: Prepare a response, with authoritative support, to Chang’s issue regarding the STARKER escrow: What is it and is it applicable to the present situation?