Corporate Finance problem in Schweser Mock Exam 3PM (#105):
Scenario II No significant expansion undertaken. The only capital expenditure would be the replacement of existing equipment. Existing brewing equipment would be sold for $2.2 million and replaced with new equipment costing $3.8 million. The old equipment is three years old and is being depreciated over five years with no salvage value in the financial statements. BATNM received 100% of the cost of the old machine as a tax deduction when it was purchased three years ago because the company is located in a designated tax enterprise zone. The new equipment would similarly qualify for a 100% deduction allowance in the year of purchase. Note that as a result of the replacement of equipment, inventory levels would increase by $200,000.
The initial outlay to be included in Marlinton’s NPV calculation for the project in scenario II is closest to:
A) $3,250,000
B) $2,900,000
C) $2,570,000
_ Solution: _
Outlay Proceeds from sale 2,200,000 2,200,000 Tax base 0 (full allowance in year 1) Taxable gain 2,200,000 Tax rate 35% Tax payable 770,000 (770,000) Cost new machine 3,800,000 (3,800,000) Investment in working capital 200,000 (200,000) Net outlay (2,570,000)
Note that investment in working capital is not tax deductible. Annual tax allowable depreciation on the new machine would be relevant when calculating the tax paid for operating cash flows (at the end of the year).
_ My question: _
This seems pretty straight forward, but I’m confused why we wouldn’t consider the tax benefit from the purchase of the new machine. Is it because the cash benefit doesn’t come until the end of the year? If so, would we include it in the Y1 CF? Doesn’t seem right that we would ignore the tax benefit.