Big-Pear Corp. is considering replacing its existing equipment that is used to produce smart cell phones. This existing equipment was purchase 2 years ago at a base price of $48,000. Installation costs at the time for the machine were $7,000. The existing equipment is considered a 5-year class for MACRS. The existing equipment can be sold today for $60,000 and for $30,000 in 4 years. The new equipment has a purchase price of $145,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $8,000. The estimated salvage value of the new equipment in year 4 is $70,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $12,000 a year. Due to these savings, inventories will see a one time reduction of $3,000 at the time of replacement. The company's marginal tax rate is 33% and the cost of capital is 12%. For this project, what is the incremental cash flow in year 3

-$7,525.44

Explanation:

MACRS 5 year depreciation

if project is carried out:

initial outlay = {[$60,000 - ($55,000 x 52%)] x (1 - 33%)} - $145,000 - $8,000 + $3,000 = -$128,962

cash flow year 1 = [$12,000 - ($154,000 x 20%)] x 0.67 = -$12,596

cash flow year 2 = [$12,000 - ($154,000 x 32%)] x 0.67 = -$24,977.60

cash flow year 3 = [$12,000 - ($154,000 x 19.2%)] x 0.67 = -$11,770.56

cash flow year 4 = {[$12,000 - ($154,000 x 11.52%)] x 0.67} + {[$70,000 - ($154,000 x 17.28%)] x (1 - 33%)} = -$3,846.34 + $29,070.50 = $25,224.16

if project is not carried out:

cash flow year 1 = -$10,506 x 0.67 = -$7,0752.20

cash flow year 2 = -$6,336 x 0.67 = -$4,245.12

cash flow year 3 = -$6,336 x 0.67 = -$4,245.12

cash flow year 4 = (-$3,168 x 0.67) + ($30,000 x 0.67) = $17,977.44

incremental cash flow year 3 = -$11,770.56 - (-$4,245.12) = -$7,525.44

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