New diesel locomotives will cost a railroad $600,000 each and can be depreciated straight-line over their five-year life. Using a diesel instead of a coal-fired steam locomotive will save $12,000 annually in operating expenses. Railroads have a required rate of return of 10 percent and a tax rate of 40 percent.
a. What is the maximum price a railroad would be willing to pay for a coal-fired steam locomotive? (Hint: Set up the cash flows for a coal-fired locomotive at a price of P, including depreciation, and then compare them to the incremental cash flows associated with a diesel costing $600,000.)
b. Will your answer to (a) change if the railroad has enormous tax-loss carryforwards that put it in a zero taxpaying position for the foreseeable future?