Case Scenario:
Oceanic Boatworks is considering purchasing a new machine for $1 million at the end of Year 0 to be put into operating at the beginning of Year 1. The new machine will save $250,000, before taxes, per year from the cash outflows generated by using the old machine. For tax purposes, Oceanic will depreciate the new machine in the following amounts: $100,000 in Year 1, $300,000 in Year 2, and $200,000 per year thereafter until fully depreciated or sold. The new machine will have no salvage value at the end of Year 5. Oceanic expects the new machine to have a market value of $400,000 at the end of three years.
If Oceanic acquires the new machine at the end of Year 0, it can sell the old one for $200,000 at that time. The old machine has a tax basis of $300,000 at the end of Year 0. If Oceanic keeps the old machine, the company will depreciate it for tax purposes in the amount of $100,000 per year for three years, when it will have no market value.
Oceanic pays taxes at the rate of 40 percent of taxable income and uses a cost of capital of 12 percent in evaluating this possible acquisition. Oceanic has sufficient otherwise taxable income in Year 0 to save income taxes for each dollar of loss it may incur if it sells the old machine at the end of Year 0.
Q1. Compute the net present value of cash flows from each of the alternatives facing Oceanic Boatworks.
Q2. Make a recommendation to Oceanic Boatworks.
Q3. Assume that the cash flows described in the problem for Years 2 through 5 are real, not nominal, amounts, but the 12 percent cost of capital includes an allowance for inflation of 6 percent. Describe how this will affect your analysis.