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A capital budgeting problem faced by tan-talize, inc. When considering the purchase of a new molding machine. The company had already purchased a machine for $40,500 and is depreciating it using the macrs method. A salesman from los angeles machine tool company offered a technically superior machine for $50,000, promising annual savings of $17,000 in cash operating costs. Ms. Miller, the production manager, is hesitant to make the switch due to sunk costs and the potential loss on the old machine. Financial calculations using net present value, internal rate of return, modified internal rate of return, profitability index, payback period, and tax implications to help determine whether the proposed equipment should be purchased.
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Tan-talize, Inc.
(Sunk Costs)
On January 2nd, Tan-talize, Inc. installed a brand new special molding machine for producing a new line of
suntan products. The machine had a cash cost of $40,500 and is to be depreciated using the 3-year column of the
MACRS table. The machine has an expected life of four years and a disposal value of zero at the end of four
years.
On January 3rd, Art Taitt, a salesman for Los Angeles Machine Tool Company, called on Glynda Miller,
production manager of Tan-talize. During the course of their conversation, Mr. Taitt told Ms. Miller: “I wish I
had known earlier of your purchase plans. Our company can supply you with a technically superior machine for
$50,000. The old machine has a salvage value of $8,000 today. I can guarantee that our machine will save you
$17,000 per year in cash operating costs, although it too will have no disposal value at the end of four years.”
Mr. Taitt provided some technical data for Ms. Miller to examine. Although she had confidence in Mr. Taitt’s
data, Ms. Miller contended: “I’m locked into my previous decision. My alternatives are clear. Disposal will
result in a loss on the present machine. Moreover, keeping and using the present equipment avoids such a loss. I
have enough sense to avoid a loss when my only other alternative is to recognize a loss. I have to use the present
equipment until I can get my money out of it.”
Assume that income tax rates are 35% on ordinary income. The minimum desired rate of return, after taxes, is
Cost of New Asset $50,
Shipping 0
Working Capital 0
Sale Proceeds (8,000)
Tax on Sale of Old Asset (see below) (11,375)
Total Cash Outflows (Initial Investment) $30,
Original Cost $40,500 Selling Price $8,
Book Value $40,500 Gain (Loss) ($32,500)
Total Tax = Gain * Tax rate = ($32,500) x 35% = ($11,375)
Depreciation Depreciation Change in
on New Asset - on Old Asset = Depreciation
Next Year = $16,650 - $13,487 = $3,
Year 2 = 22,250 - 18,023 = 4,
Year 3 = 7,400 - 5,994 = 1,
Year 4 = 3,700 - 2,997 = 703
Net Change in
Savings x (1 - T.R.) + Depreciation x Tax Rate = Cash Inflow
1 $17,000 x 0.65 + $3,164 x 0.35 = $12,
2 17,000 x 0.65 + 4,228 x 0.35 = 12,
3 17,000 x 0.65 + 1,406 x 0.35 = 11,
4 17,000 x 0.65 + 703 x 0.35 = 11,
There are no terminal cash flows associated with the new machine (i.e., salvage value is zero, therefore there is
no tax to be paid upon disposal, and there is no working capital requirement.).