Analyzing cash flows from alternatives. Coalinga Hospital is considering replacing some machinery. The old machinery has book value and tax basis of $10,000. Its current market value is $5,000. Coalinga Hospital does not have the alternative of simply selling the old machinery now. It must either use it for another year or replace it. Coalinga Hospital has been depreciating the old equipment on a straight-line basis at the rate of $10,000 per year. If Coalinga Hospital retains the machinery it will depreciate the remaining tax basis over one year and the financial book value over three years. The machinery will have no market value one year hence.
Coalinga Hospital can acquire new machinery for $30,000, which will produce $10,000 of cash savings at the end of the first year. The new machinery will produce cash savings at the end of Year 2 that is 5 percent greater than at the end of Year 1, and at the end of Year 3 the savings will be 5 percent greater than at the end of Year 2. The new machinery will have a three-year life. Coalinga Hospital will depreciate the equipment on a straight-line basis over three years for both tax and financial reporting purposes. It will sell the machinery for $2,000 at the end of Year 3 but will ignore salvage value in tax depreciation computations. Coalinga Hospital pays income taxes at the rate of 40 percent for both ordinary income and capital gains. The cost of capital for the new machinery, after taxes, is 12 percent per year. Coalinga Hospital earns sufficient taxable income that it can deduct from its taxes payable at the beginning of Year 1 (¼ end of Year 0) the loss from disposition of the old machinery at the beginning of Year 1 (¼ end of Year 0).
Analyze the present value of the cash flows of the alternatives and make a recommendation to Coalinga Hospital.