Verla Industries is trying to decide which one of the following two options to pursue. Either option will take effect on January 1st of the next year.... Accounting MCQs | Accounting MCQs

Verla Industries is trying to decide which one of the following two options to pursue. Either option will take effect on January 1st of the next year.
Option One - Acquire a New Finishing Machine.
The cost of the machine is $1,000,000, and it will have a useful life of 5 years. Net pre-tax cash flows arising from savings in labor costs will amount to $100,000 per year for 5 years. Depreciation expense will be calculated using the straight-line method for both financial and tax reporting purposes. As an incentive to purchase, Verla will receive a trade-in allowance of $50,000 on their current fully depreciated finishing machine.
Option Two - Outsource the Finishing Work.
Verla can outsource the work to LM, Inc., at a cost of $200,000 per year for 5 years. If they outsource, Verla will scrap their current fully depreciated finishing machine.
Verla’s effective income tax rate is 40%. The weighted-average cost of capital is 10%.
Verla’s net present value of acquiring the new finishing machine is

$229,710 net cash outflow.
$267,620 net cash outflow.
$369,260 net cash outflow.
$434,424 net cash outflow.Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (D) is correct. Verla’s net present value of acquiring the new finishing machine can be calculated as follows: With the trade-in allowance, the net cost will be $950,000. This will be
depreciated over 5 years at $190,000 per year. The cash inflows consist of the $100,000 of annual cost savings, which reduces to $60,000 once taxes have been considered. Also, there will be an inflow from the depreciation shield ($190,000 × 40% tax rate, or an inflow of $76,000 per year). Combining the $60,000 after-tax savings from operations with the $76,000 of tax savings from depreciation produces a total of $136,000 of after-tax inflows annually. Discounting the five payments with the annuity factor of 3.791 (5 years at 10%) produces a present value of $515,576 ($136,000 × 3.791). Subtracting the present value of the inflows from the $950,000 initial outlay results in a net outflow of $434,424.