Powell Corporation, a large, diversified manufacturer of

Powell Corporation, a large, diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380,000, and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-year recovery period. The present (old) machine was purchased 3 years ago at a cost of $240,000 and was being depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine and to remove it at the buyer’s expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement; these changes will result in a $17,000 ($35,000 – $18,000) increase in net working capital. Both ordinary income and capital gains are taxed at a rate of 40%. The only component of the initial investment calculation that is difficult to obtain is taxes. Because the firm is planning to sell the present machine for $40,000 more than its initial purchase price, a capital gain of $40,000 will be realized. The book value of the present machine can be found by using the depreciation percentages from Table 3.2 (page 100) of 20%, 32%, and 19% for years 1, 2, and 3, respectively. The resulting book value is $69,600 ($240,000 – [(0.20 +0.32 +0.19) ×$240,000]). An ordinary gain of $170,400 ($240,000[1] $69,600) in recaptured depreciation is also realized on the sale. The total taxes on the gain are $84,160 [($40,000 + $170,400) × 0.40]. Substituting these amounts into the format in Table 8.2 results in an initial investment of $221,160, which represents the net cash outflow required at time zero.