After-Tax EUAC Analysis (Restatement of Example 9-3 with Tax Information) The manager of a carpet manufacturing plant became concerned about the operation of a critical pumpin one of the processes. After discussing this situation with the supervisor of plant engineering, they decided that a

Question

After-Tax EUAC Analysis (Restatement of Example 9-3 with Tax Information)

The manager of a carpet manufacturing plant became concerned about the operation of a critical pump in one of the processes. After discussing this situation with the supervisor of plant engineering, they decided that a replacement study should be done and that a nine-year study period would be appropriate for this situation. The company that owns the plant is using an after-tax MARR of 6% per year for its capital investment projects. The effective income tax rate is 40%.The existing pump, Pump A, including driving motor with integrated controls, cost $17,000 five years ago. The accounting records show the depreciation schedule to be following that of an asset with a MACRS (ADS) recovery period of nine years. Some reliability problems have been experienced with Pump A, including annual replacement of the impeller and bearings at a cost of $1,750. Annual expenses have been averaging $3,250. Annual insurance and property tax expenses are 2% of the initial capital investment. It appears that the pump will provide adequate service for another nine years if the present maintenance and repair practice is continued. An estimated MV of $750 could be obtained for the pump if it is sold now. It is estimated that, if this pump is continued in service, its final MV after nine more years will be about $200. An alternative to keeping the existing pump in service is to sell it immediately and to purchase a replacement pump, Pump B, for $16,000. A nine-year class life (MACRS five-year property class) would be applicable to the new pump under the GDS. An estimated MV at the end of the nine year study period would be 20% of the initial capital investment. Operating and maintenance expenses for the new pump are estimated to be $3,000 per year .

TABLE 9-6 Summary of Information for Example 9-12

MARR (after taxes) = 6% per year Effective income tax rate = 40%
		Existing Pump A (defender) MACRS (ADS) recovery period
Capital investment when purchased five years ago	9 year
Total annual expenses	$17,000
Present MV	$5,340
Estimated market value at the end of nine additional years	$750
Replacement Pump B (challenger)
MACRS (GDS) property class	5 years
Capital investment	$16,000
Total annual expenses	$3,320
Estimated MV at the end of nine years	$3,200

Annual taxes and insurance would total 2% of the initial capital investment. The data for Example 9-12 are summarized in Table 9-6. Based on these data, should the defender (Pump A) be kept [and the challenger (Pump B) not purchased], or should the challenger be purchased now (and the defender sold)? Use an after-tax analysis and the outsider viewpoint in the evaluation.

Accepted Answer

The after-tax computations for keeping the defender (Pump A) and not purchasing the challenger (Pump B) are shown in Table 9-7. Year zero of the analysis period is at the end of the current (fifth) year of service of the defender. The year-zero entries of Table 9-7 are computed using the general format presented in Figure 9-5 and are further explained in the following:
1. BTCF (−$750): The same amount used in the before-tax analysis of Example 9-3. This amount is based on the outsider viewpoint and is the opportunity cost of keeping the defender instead of replacing it (and selling it for the estimated present MV of $750).
2. Taxable income ($7,750): This amount is the result of an increase in taxable income of $7,750 due to the tax consequences of keeping the defender instead of selling it. Specifically, if we sold the defender now, the loss on disposal would be as follows:
Gain or loss on disposal (if sold now) = MV[latex]_{0}[/latex] − BV[latex]_{0}[/latex],
BV[latex]_{0}[/latex] = $17,000[1 − 0.0556 − 4(0.1111)] = $8,500,
Loss on disposal (if sold now) = $750 − $8,500 = −$7,750

But since we are keeping the defender (Pump A) in this alternative, we have the reverse effect on taxable income, an increase of $7,750 due to an opportunity forgone.
3. Cash flow for income taxes (−$3,100): The increase in taxable income because of the tax consequences of keeping the defender results in an increased tax liability (or tax credit forgone) of −0.4($7,750) = −$3,100.
4. ATCF (−$3,850): The total after-tax investment value of the defender is the result of two factors: the present MV ($750) and the tax credit ($3,100) forgone by keeping the existing Pump A. Therefore, the ATCF representing the investment in the defender (based on the outsider viewpoint) is −$750 − $3,100 = −$3,850.
The remainders of the ATCF computations over the nine year analysis period for the alternative of keeping the defender are shown in Table 9-7. The after tax computations for the alternative of purchasing the challenger (Pump B) are shown in Table 9-8. The next step in an after-tax replacement study involves equivalence calculations using an after-tax MARR. The following is the after-tax EUAC analysis for Example 9-12:

EUAC(6% ) of Pump A(defender) = $3,850(A/P, 6%, 9)
+ $2,448(P/A, 6%, 4)(A/P, 6%, 9)
+ [$2,826(F/P, 6%, 4)
+ $3,204(F/A, 6%, 4) − $120]
× (A/F, 6%, 9)
= $3,332;

EUAC(6% ) of Pump B (challenger) = $16,000(A/P, 6%, 9)
+ [$712(P/F, 6%, 1) − $56(P/F, 6%, 2)
+ $763(P/F, 6%, 3)
+···+ $1,992(P/F, 6%, 9)](A/P, 6%, 9)
− $1,920(A/F, 6%, 9)
= $3,375.
Because the EUACs of both pumps are very close, other considerations, such as the improved reliability of the new pump, could detract from the slight economic preference for Pump A. The after-tax annual costs of both alternatives are considerably less than their before-tax annual costs. The after-tax analysis does not reverse the results of the before-tax analysis for this problem (see Example 9-3). Due to income tax considerations, however, identical before-tax and after-tax recommendations should not necessarily be expected.

TABLE 9-7 ATCF Computations for the Defender (Existing Pump A) in Example 9-12

End of Year, k	(A) BTCF[latex]^{a}[/latex]	(B) MACRS (ADS) Depreciation	(C) = (A) − (B) Taxable Income	(D) = −0.4(C) Income Taxes at 40%	(E) = (A) + (D) ATCF
0	−$750	None	$7,750	−$3,100	−$3,850
1–4	−5,340	$1,889	−7,229	2,892	−2,448
5	−5,340	944	−6,284	2,514	−2,826
6–9	−5,340	0	−5,340	2,136	−3,204
9	200		200[latex]^{b}[/latex]	−80	120
[latex]^{a}[/latex] Before-tax cash flow (BTCF).
[latex]^{b}[/latex] Gain on disposal (taxable at the 40% rate).

TABLE 9-8 ATCF Computations for the Challenger (Replacement Pump B) in Example 9-12

End of Year, k	(A) BTCF	(B) MACRS (ADS) Depreciation	(C) = (A) − (B) Taxable Income	(D) = −0.4(C) Income Taxes at 40%	(E) = (A) + (D) ATCF
0	−$16,000	None			−$16,000
1	−3,320	$3,200	−$6,520	$2,608	−712
2	−3,320	5,120	−8,440	3,376	56
3	−3,320	3,072	−6,392	2,557	−763
4	−3,320	1,843	−5,163	2,065	−1,255
5	−3,320	1,843	−5,163	2,065	−1,255
6	−3,320	922	−4,242	1,697	−1,623
7–9	−3,320	0	−3,320	1,328	−1,992
9	−3,320		[latex]3,200^a[/latex]	−1,280	1,920

Question 9.12: After-Tax EUAC Analysis (Restatement of Example 9-3 with Tax...

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