Managerial Accounting Case based analysis assignment

THE COMPANY

XYZ Company was formed in the United States seven years

ago by Jim Smith, Marsha Chang, and Earl Watson, who

together purchased a commercial machine shop that had been

in business for more than 40 years but, at the time of the

acquisition, was feeling pressure from a variety of new entrants

into the markets in which the machine shop competed. Smith

had a distinguished military career and felt he could use the

skills he acquired in the military to help this business return to

its previously highly profitable state. Smith currently serves as

the president and CEO of the company.

XYZ produces three primary product lines, all of which are

made of brass and are water-related: flow controllers, valves,

and pumps. Marsha Chang, a long-time friend of Smith and

his family, and a practicing CPA (Certified Public Accountant)

and CMA® (Certified Management Accountant), joined the

company as its CFO shortly before the formation of XYZ.

Earl Watson, a high school friend of Smith, had worked as the

manufacturing supervisor at the company for the past 10 years

and, at the request of Smith, decided to stay onboard after the

formation of XYZ. Over the past several years, Watson had

toyed with the idea of introducing more technologically up-

to-date equipment that, he thought, could help ameliorate the

competitive position of the company.

Recently, Chang instituted an activity-based costing

(ABC) system and a “bare-bones” Enterprise Resource

Planning (ERP) system that, among other things, helped the

company assess customer profitability and price its products

more competitively. A new marketing manager, Maria

Sanchez, was hired last year to develop and implement an

aggressive product-promotion plan.

These combined changes helped turn the company

around. Two years ago, to raise capital needed for an

expansion of the plant and the modernization of certain

equipment key to the manufacturing process, the company

went public. The company was enjoying a renewed

reputation as a producer of high-quality brass products, sold

principally in the southeast region of the U.S. XYZ was, in

fact, profitable in each of the past four years.1 At the end

of the most recent year, total assets were approximately

$10 million. Over the past two years, sales for the company

amounted to approximately $25 million per year. The

company’s fiscal year corresponds to the calendar year.

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ISSN 1940-204X

XYZ Company: An Integrated Capital Budgeting Instructional Case

David E. Stout Andrews Chair in Accounting Lariccia School of Accounting & Finance Williamson College of Business Administration Youngstown State University [email protected]

Raymond J. Shaffer Lariccia School of Accounting & Finance Williamson College of Business Administration Youngstown State University [email protected]

Jeremy T. Schwartz Lariccia School of Accounting & Finance Williamson College of Business Administration Youngstown State University [email protected]

© 2 0 1 5 I M A

THE PROPOSED INVESTMENT: AN ASSET-REPLACEMENT DECISION

Assume that it is sometime in the fourth quarter of 2014.

Watson has presented to Smith and Chang a proposal to

purchase a replacement to a machine used to manufacture

one of the three products. The existing machine was

purchased on January 1, 2013. Assume that the asset

replacement, if it occurs, will take place on January 1, 2015.

Thus, the issue before Smith, Chang, and Watson is whether

to keep the existing machine or to replace it with a new,

more technologically advanced machine.2

ADDITIONAL ASSUMPTIONS REGARDING THE CAPITAL BUDGETING DECISION

XYZ uses two discounted cash flow (DCF) models—net

present value (NPV) and internal rate of return (IRR)—to

assess capital investment proposals, including the current

asset-replacement decision. Because XYZ has been a listed

company for only a short period of time and is thinly traded,

Chang has recommended that, for discounting purposes,

the company should use 10% (an estimate of XYZ’s after-tax

weighted average cost of capital [WACC]). In conjunction

with your evaluation of the investment proposal at hand, you

can assume the following additional facts:

• The tax law that governs this decision is the U.S. income

tax law that is (or was) in effect for 2015.

• The proposed acquisition date is January 1, 2015, which

can therefore be considered “time period 0” for purposes

of your DCF analysis.

• Depreciation on the proposed investment for tax purposes

will be calculated using the appropriate rates (to be

determined by you) under MACRS half-year convention.

As previously noted (see Endnote #2), this means that a

half-year’s worth of depreciation is taken in the year of

asset disposal, regardless of the date of sale within the year.

For financial reporting purposes, the straight-line (S/L)

method is used to record depreciation charges.

• Over the past two years, the marginal income tax rates

paid by XYZ are: local 5%, state 10%, and federal 25%.

For analysis purposes, assume that marginal tax rates for

XYZ will, during the years covered by this case, remain

constant and equal to the preceding amounts.

• Unless otherwise noted, assume that the company

does NOT elect to take advantage of write-offs (if

any) allowed by Internal Revenue Code (IRC) §179,

“Election to expense certain depreciable business

assets,” but DOES decline to take “bonus depreciation”

(if applicable, and as outlined in IRC §179).

• Prior to considering the capital budgeting decision at

hand, the company has already committed to $2 million

of other capital expenditures for 2015.

• For simplicity, the timing convention for discounting

estimated after-tax cash flows to present value is:

• All pre-tax operating cash flows, taxes on pre-tax

cash flows, and income tax effects from depreciation

deductions occur at the end of each year. For example,

time-period-1 operating cash flows are assumed to be

received by XYZ on December 31, 2015. Likewise,

taxes on these cash flows as well as time-period-1 tax

savings due to MACRS-based depreciation deductions

are assumed to occur on December 31, 2015.

• Opportunity costs (if any) associated with the decision

to replace the existing asset are assumed to occur at the

end of year 1 (that is, on December 31, 2015).

• If the old asset is sold, the pre-tax cash inflow from this

sale is assumed to occur at the point of sale (at time

period zero, January 1, 2015). By contrast, tax savings

associated with the half-year depreciation deduction on

the old asset under MACRS are assumed to occur at the

end of the year, December 31, 2015.

BASE-CASE ANALYSIS: KEEP OR REPLACE THE EXISTING MACHINE?

The current machine, which is being considered for

replacement, was purchased on January 1, 2013, for $120,000

with an estimated useful life of 12 years and zero salvage value

for financial reporting purposes.3 The estimated disposal value

of this machine on January 1, 2015, is $36,000. If not disposed

of (i.e., if not sold outright), it is estimated that the current

machine could be used for another 10 years (i.e., the same

total number of years as its original estimated useful life).

The base purchase price for the replacement machine

is $170,000.4 Delivery cost for the machine, to be born

separately by XYZ, is estimated as $5,000. Installation

and testing costs for the new machine are estimated to

be $25,000. In the past, XYZ has “charged” each major

investment project with an administrative fee equal to 10%

of the purchase price of the asset (investment). This imputed

fee represents an allocation of corporate headquarters’ (i.e.,

“overhead”) expense.

During the discussion of the proposed investment,

Watson pointed out that if the company purchases the

replacement machine, it is likely to lose some business

during the time the old machine is being removed and the

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replacement machine is installed (and tested). His best

guess—and it is only a guess—is that the contribution margin

lost during this time would be $5,000 (pre-tax).5

If the replacement asset is purchased, pre-tax operating

cash flows are expected to increase by $35,000 per year.6

The new machine is technologically advanced, which is

expected to provide two benefits: (1) a reduction in annual

cash operating expenses and (2) an increase in sales volume.

The latter is attributable to the greater output capacity of the

replacement machine. The new machine has an expected

useful life of 10 years.7

DEALING WITH UNCERTAINTY: SENSITIVITY ANALYSIS

The decision team is aware that many assumptions will

be going into the DCF analysis of the present asset-

replacement decision.8 Team members are therefore curious

as to how sensitive the replacement decision is with respect

to each of the following issues or considerations:

• The discount rate (WACC) used to estimate the present

value of after-tax cash flows;

• The amount of annual after-tax operating cash inflow

associated with each investment alternative (keep vs. replace);

• The estimated useful life of each of the two assets (i.e.,

these lives may be different); and

• The possible need to account for an additional

investment in (net) working capital should the company

purchase the replacement machine.

In terms of the assumed discount rate, Watson offered the

following observations at a recent business meeting with Smith

and Chang: “OK, we see that on the basis of our DCF analysis

one decision option is preferable (in a present-value sense).

This analysis assumed an after-tax discount rate (i.e., a WACC)

of 10%. Is this the correct amount? Does the rate we use

‘matter’ in terms of our assessment of the present investment

proposal? Over the weekend, I came across a Harvard Business

Review article that suggested we might have to give more

thought to this issue.9 What do you folks think?”

At the next planning meeting, Watson raised another

sensitivity-analysis issue: “Well, we addressed the issue of

how sensitive our recommended course of action would be

in terms of the assumption regarding the discount rate used

in our DCF decision models. It seems to me, however, that

there are other areas of concern regarding the numbers we

used in our base-case analysis. Key concerns among these

might be the ‘guestimates’ we are making—and up to 10

years out!—regarding the annual pre-tax operating cash

inflows associated with each decision alternative. I think

we have a pretty good handle on the operating cash flows

associated with the existing asset. After all, we’ve been using

that machine now for two years. The operating cash flow

estimate associated with the replacement asset, on the other

hand, was determined in conjunction with the discussions

we had with the sales agent for the new machine, which

suggests to me the possibility that those estimates could be,

well, overly optimistic. I know we are dealing with a lot of

assumptions here. To keep the analysis manageable, let’s go

with the discount rate we used in our base-case analysis, 10%

(after-tax), and let’s assume the use of NPV as our decision

model. I’m curious as to how sensitive our recommendation

is with respect to the assumption we are making regarding

the amount of annual pre-tax operating cash inflows

associated with the replacement asset. Perhaps we can rely

on Excel to help us explore this issue.”

At that point, Watson said: “Two-plus years ago I was

involved in the decision to purchase the existing asset. At the

time, I remember we factored into the decision the amount

of ‘net working capital’ we thought necessary to support the

increased sales volume associated with our investment. I

also remember that the amount was something like $20,000.

I’m not really sure what this is all about, but I’m thinking

that we should at least address this issue. At a minimum, I

think we should answer some questions: (1) Conceptually,

do we need to amend our base-case analysis to incorporate

this information? Why or why not? (2) Assuming we replace

the existing asset with the new machine, we would have to

commit another $20,000 of (net) working capital to support

the anticipated increase in sales. Would this affect our

recommended course of action?”

Before the meeting concluded, Smith commented:

“Since we’re on the subject, does anyone here think it’s

strange that we’re assuming, in our base-case analysis, that

the useful life of each asset—both the existing asset and

the replacement asset—are equal, that is, 10 years? I would

agree that the existing asset is likely to last another 10 years.

But I’m not so sure about the replacement asset. Yes, it’s

supposed to be more efficient, and it’s supposed to increase

our sales volume—hence the additional projected pre-tax

operating cash inflows each year. But I did some research

on my own recently, and, on the basis of this research, I feel

that a more conservative estimate of the useful life of the

replacement asset may be eight rather than 10 years. So, if

this is true, we’re now left with the unfortunate situation of

having to compare two assets of unequal lives. How do we do

this analytically?”

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The meeting then concluded. All three team members

felt comfortable that the team had identified the primary

sources of uncertainty regarding the NPV analyses they were

about to conduct. At the request of Chang, the next team

meeting would be devoted to raising tax-related questions

regarding the proposed acquisition.

ADDITIONAL TAX CONSIDERATIONS

At the end of the following week, the team reconvened to

discuss three tax-related issues that arose from their informal

conversations during the week: (1) the issue of “like-kind

exchanges,” (2) the possibility of taking an accelerated write-

off, and (3) the possible use of a “STARKER escrow” for the

sale of the existing machine (if the decision were made to

replace that machine).

Smith began the meeting by saying: “Well, we’ve covered

a lot of ground here so far, but I wonder whether we’re missing

something important from a tax standpoint. For example, our

baseline DCF analysis assumes that we’re going to sell the

existing asset outright in the open market. In fact, we have a

firm offer from a reputable buyer for the existing machine. But

I wonder: (1) Would there be any tax advantage to trading in

(rather than selling outright) the old asset, under the assumption

that the trade-in amount would be equal to, say, the agreed-

upon external sales price, $36,000? (2) If we were to negotiate

a trade-in value, what would the breakeven value be? That is,

can we come up with the trade-in value that would make us

indifferent between keeping and replacing the existing asset?

To make the analysis tractable, let’s assume data associated with

our base-case scenario and the use of NPV analysis to address

this question.” Chang agreed that Smith’s point was interesting

and worth exploring. She pointed out that the relevant tax law

pertaining to this issue is covered in IRC §1031, “Exchange of

property held for productive use or investment.”

Smith continued, “I also recall that two years ago,

when we purchased the existing machine, we talked about

expensing the machine immediately, under (I think) IRC

§179. I don’t remember the details, but I do remember

someone making the point that this election could have

saved us more than a trifling amount in terms of our tax

bill. I really can’t remember why we chose not to go that

route. Chang, in your opinion, is this option available this

year? Would it benefit us? Why or why not? I think we

need to address these questions as we evaluate the present

investment opportunity.” Chang replied, “I remember an

article from a couple of years ago that dealt with these very

issues.10 I’ll retrieve and reread it—it may be relevant to the

present decision analysis.”

Chang continued, “Speaking of additional tax-related

issues, I recently read something—in the Bozeman Daily

Chronicle of all places!—that might apply to our situation:

using a so-called STARKER escrow in conjunction with a

possible disposal of our existing asset. I never heard of such

a thing, but I’m intrigued about this possible tax-related

option. I wonder whether this STARKER thing would apply

to our situation.”

STRATEGIC/QUALITATIVE CONSIDERATIONS: BEYOND THE “NUMBERS”

Then, Smith commented: “I think we’ve done a pretty

good job covering all of the financial dimensions of the

present decision, including some interesting income tax

considerations. As agreed to in our earlier meetings, our base-

case analysis will be supplemented with various sensitivity

analyses. At this point, I think we should ask ourselves

whether we’ve covered all relevant aspects of the proposed

decision. Why don’t we call in Mark Callaway to see whether

we are missing something here—something that goes

beyond the ‘numbers’? I’m concerned, for example, about

whether we have properly considered any pertinent strategic

or qualitative considerations.”

Smith knows that, at a minimum, it will be prudent to

consult with Mark Callaway, director of Investor Relations

for XYZ. After hearing the back story for the proposal

and examining the underlying data discussed thus far by

the team, Callaway skeptically responds, “We have been

profitable the past two years with the current machine. What

you are proposing is giving me a public relations headache—

if we sell the old machine, we could very well take a hit on

our published financial statements for the first quarter of

2015 and perhaps beyond.”

Smith interjects, “On paper, Callaway. The sale of the

existing machine would actually provide a tax benefit.”

Callaway responds, “Yes, we record a loss for financial

reporting purposes, but it’s truly a loss since we paid

$120,000 for the machine, used it for only two years, and now

will receive only $36,000 for it. That’s quite a rental fee!”

Smith concedes, “You have a point there.”

Callaway continues, “We are also pushing aside business

during the transition period.”

Watson speaks up. “Temporarily, this should only be a

minor delay.”

Callaway retorts, “So you say. Forgive me for my

skepticism, but I would be concerned about how long this

‘minor’ delay will be. You were the one who promoted the

current machine, which is supposed to last another decade

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 8 , N O . 1 , A R T. 1 , M A R C H 2 0 1 54

but now isn’t good enough? Two years ago we raised capital

in part by promising profits through use of the current

machine, which profits you have delivered thus far. Now,

you’re asking the company to cough up even more money

for a replacement machine, which may or may not be more

profitable. As well, you’re telling me that the new machine

may actually have a shorter useful life than the existing

machine it’s supposed to replace.”

Watson rejoins, “It will be more profitable. As noted in

the DCF analysis we performed, we anticipate having both

operational cost savings and increased sales volume due to

increased capacity of the new machine.”

Callaway shakes his head, saying, “Look, I think it’s great

that you’re looking for ways to increase the value the company

and our bottom line. I’m concerned, however, that you’re

being overly optimistic. Do you have a handle on how many

more units we can sell? Will the cost savings allow us to reduce

price to the point where we maintain margins? Best-case

scenario, we take a step back only in the next quarter, entirely

due to changing the machines. Worst-case, the new machine

enables us to produce much more than we can sell, and we’re

stuck squeezing margins to move our products.”

Smith intercedes, “But, we have a real opportunity for

growth with the new equipment.”

Callaway responds, “Yes, but is bigger really better? I’m

leery of making this proposed financial commitment. So much

has to go right for us. Let’s assume that Watson is right about

the cost savings from using the new machine. That would be

great, but for what production range will that be valid? Will we

really be able to sell enough to make it worthwhile?”

Watson remains emboldened, “I guarantee that the

replacement machine will be worth it. You’re focusing too

narrowly on the short-term adjustment period.”

Callaway replies, “Yeah, but how do I know that you

won’t come back again in two years asking the shareholders

to buy another toy that you say will last 10 years?”

Smith brings the matter to a close. “Callaway, we’ll take

your concerns under advisement. I’m confident that you’ll be

effective in explaining to our investors any short-term hiccups

in profits. But we’re putting the cart before the horse here. I

think that Watson, Chang, and I need to run the numbers to

assess the short-term financial-reporting effect of our decision.”

As Callaway walks off, Smith turns to Chang and Watson:

“Our earlier discussion with Callaway has made me step back

a bit and think more broadly about the decision we’re facing.

My sense is that it would be worthwhile for us to supplement

our financial analysis with a listing of strategic and/or qualitative

factors that are associated with this decision. I guess my

concern is whether ‘the numbers’ capture all pertinent

aspects of this decision. What do you think? At a minimum,

I suggest we address the following questions: (1) Are there

important strategic considerations associated with each decision

alternative? If so, what are they? (2) If the answer is ‘yes,’ have

we already captured the effect of these factors in our financial

analysis? If not, what exactly do we do with this information?

That is, is there a way for us to incorporate both financial and

nonfinancial information formally into our decision process?”

Chang and Watson agreed that these were legitimate questions

to address in conjunction with the proposed acquisition.

PROJECT EVALUATION SUMMARY

At the conclusion of the meeting, Watson said: “We’ve really

covered a lot of territory here, to the point that we now have

what might be viewed as a bewildering array of facts, figures,

and calculations. Can we put our heads together and craft a

useful summary of our analyses—perhaps in the form of a table?

I know I’d find this very helpful. I think this would be a nice

way to prepare for the final meeting, at which time we’ll make

a decision regarding the asset replacement.” Smith and Watson

agreed to work with Chang over the next few days to prepare a

project evaluation summary report that could be used to guide

the discussion scheduled for the following week.

CASE REQUIREMENTS

1. Base-case analysis:11 Should the replacement asset be

purchased? That is, does it make economic (financial) sense

for XYZ to replace the existing machine? Support your

answer by clearly showing the tax basis of the replacement

asset (if purchased and under the assumption that the

existing asset would be sold outright rather than traded

in) and the annual after-tax cash flows associated with

both decision options. Remember to record appropriate

depreciation expense under MACRS for the existing

asset, assuming it is sold January 1, 2015. Recall that the

pre-tax cash flow from the disposal of the existing asset is

assumed to occur on January 1, 2015, while the tax savings

due to depreciation deductions under MACRS, as well as

tax-related effects of the disposal (if any), are assumed to

be realized at the end of 2015. Base your recommendation

on both an NPV analysis and a comparison of the IRR

associated with each of the two investment alternatives

(keep vs. replace). Comment on your comparative results.

Round all calculations, including intermediate calculations,

to whole numbers (i.e., to zero decimal points).

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2. Dealing with Uncertainty/Sensitivity Analysis:

a. Issues related to the discount rate: How (conceptually)

is the discount rate for capital budgeting purposes

defined and calculated? Is this number appropriate for

analyzing the asset-replacement decision at hand? Why

or why not? What impact, if any, would a rate below or

above 10% have on the recommended course of action

for XYZ Company? To address this issue, first prepare

a schedule in Excel showing what the NPV results of

the base-case analysis would be after letting the WACC

vary from a low of 8% to a high of 13%, in increments

of 1%. For each discount rate, recalculate the difference

in NPV of the two investment alternatives. Next, use

the Data Table option in Excel to perform and present

the results of this sensitivity analysis. Finally, using the

Goal Seek option in Excel, determine the “breakeven”

discount rate, that is, the rate that would make XYZ

indifferent between the two decision options (based on

an NPV analysis of the base-case facts).

b. Estimates of annual pre-tax cash inflows of the

replacement machine: Use the Goal Seek option in

Excel to determine the breakeven operating pre-tax

cash inflow associated with the replacement asset (i.e.,

the annual pre-tax cash inflow for the replacement

machine that would make XYZ indifferent between

keeping vs. replacing the existing machine). What keen

managerial insight is yielded from this analysis?

c. Addressing incremental investment in (net) working

capital: Respond to the two queries raised by Watson

regarding the possible need to make an up-front

commitment of additional (net) working capital if

the replacement machine is purchased: (1) Does the

base-case anºalysis need to be changed? Why or why

not? (2) If the team replaces the machine, XYZ would

have to commit to incremental (net) working capital of

$20,000. Would this incremental investment affect the

recommended course of action? (Show calculations.)

d. Unequal asset lives: Under the assumption that the

useful lives of the two assets differ, a possibility noted

by Smith, and based on the use of the NPV decision

model, provide a recommendation as to which asset

XYZ should choose. Support your answer with

appropriate calculations and citations to the literature.

3. Additional Tax-Related Issues:

a. Like-kind exchanges, IRC §1031: Prepare a response with

supporting calculations (if appropriate) to the two tax-

related questions raised by Smith in conjunction with the

possibility of trading in rather than selling the existing

machine outright (if the new machine were purchased):

(1) Would there be any tax advantage to trading in (rather

than selling) the old asset? (2) What would the breakeven

value of the trade in be? Note: When responding to

Smith’s second question, assume base-case data. For

purposes of responding to this question, you can ignore

the incremental investment in net working capital (if any)

that would be required if the new asset is purchased.

b. Applicability of IRC §179: Prepare a response, with

appropriate authoritative support, to the two questions

raised by Smith regarding the provisions of IRC §179, as

it pertains to expensing of the cost of the replacement

asset: Does XYZ have this option? What are the benefits

of this option (if any)?

c. Use of a STARKER escrow in conjunction with the

disposal of the existing asset: Prepare a response, with

authoritative support, to Chang’s issue regarding the

STARKER escrow: What is it and is it applicable to

the present situation?

4. Strategic and/or Qualitative Considerations/Multi-Criteria

Decision Models:

a. Incentive effects: Calculate the book loss (i.e., the loss for

financial reporting purposes) that Callaway references

regarding the disposal (i.e., the outright sale) of the old

machine. What effect should the book value have on the

decision to purchase the new machine? How will external

users, such as shareholders, likely react to this information?

What incentive does Watson have in representing the

length of time for retooling? How might the present

decision affect customer relations? What general issue

regarding incentive effects and the design of management

accounting control systems is raised by this example?

b. Demand and pricing-related considerations: Expand on

Callaway’s criticisms from a strategic perspective. For

example, what does he mean by “squeezing margins”?

What economic assumption regarding price elasticity

of demand is XYZ making for its products? How does

XYZ balance its desire to gain market share through

cost efficiencies with the “commitment” it made to

shareholders regarding the original machine?

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c. Additional qualitative/strategic considerations and the use of

multi-criteria decision models: Prepare a response to the two

questions raised by Smith regarding strategic/qualitative

considerations associated with the proposed investment:

(1) What additional nonfinancial/strategic factors (beyond

those discussed in 4(a) and 4(b)) might bear on the decision

facing XYZ Company? (2) How could such factors (if any)

be formally incorporated into a capital budgeting analysis?

To the extent possible, support your position by offering

several additional qualitative/strategic considerations and

by referencing the appropriate literature (e.g., the literature

pertaining to “multi-criteria decision making” models as

applied to a capital budgeting context).

5. Project Evaluation Summary: Prepare a summary report

(in the form of a table) that reflects the major issues

addressed in the case. Each row in your table should

deal with a separate issue you addressed. For each issue,

provide a statement as to whether and why (or how) the

issue at hand would affect the recommended decision as

well as any additional information you think is pertinent.

Assume that the document you prepare would be the

type that could be used to guide the discussion at the

decision team’s final meeting (or the presentation of your

report to a client) and that the project evaluation summary

would be supported by the various analyses conducted in

conjunction with answering previous case questions.

ENDNOTES

1 As such, the company currently has no operating loss

carryforwards for U.S. tax purposes.

2 By the time of the investment decision (January 1, 2015),

the machine in question would have recorded two years’

worth of depreciation for financial reporting purposes and

two and a half years’ worth of MACRS-based depreciation

for tax purposes. Under current MACRS rules, a half-year

of depreciation is taken in the year of asset disposal. Since

the proposed transaction is assumed to occur on the first

day of the fiscal year, under MACRS (Modified Accelerated

Cost Recovery System) XYZ would record a half-year of

depreciation expense for the existing asset for tax purposes

for 2015.

3 Annual depreciation expense for financial reporting

purposes = (Purchase price – Salvage Value) / Useful Life.

In the present case, depreciation charges = ($120,000 − $0) /

12 years = $10,000 per year.

4 Currently, there is no sales tax in the state in which XYZ is

located.

5 For simplicity (as noted above), assume that these effects

occur at the end of year 1 (i.e., on December 31, 2015).

6 Pre-tax operating cash inflows from using the new machine

are estimated as $55,000 per year. Pre-tax operating cash

inflows from using the existing machine are assumed to be

$20,000 per year.

7 Note that this can be different from the period over which

depreciation on the asset is recorded under MACRS for

U.S. income tax purposes.

8 In structuring the DCF analysis of the present asset-

replacement decision, you may want to consult a corporate

finance or intermediate-level financial management

textbook and/or the following article: Su-Jane Chen

and Timothy R. Mayes, “A Note on Capital Budgeting:

Treating a Replacement Project as Two Mutually Exclusive

Projects,” Journal of Financial Education, Spring/Summer

2012, pp. 56-66.

9 Michael T. Jacobs and Anil Shivdasani, “Do You Know Your

Cost of Capital?” Harvard Business Review, July 2012,

pp. 118-124.

10 Richard Mason, Sonja Pippin, and Anthony Curatola,

“Expensing vs. Capitalizing Business Property in Light of

ATRA,” Strategic Finance, April 2013, pp. 8-12.

11 Note that all tax-related questions and calculations in the

case pertain to U.S. tax law in effect at the indicated date.

This law may change over time (which suggests the need

for accountants to maintain up-to-date knowledge in the

area). Further, the tax laws in effect in countries other than

the U.S. may produce different results from those based on

U.S. tax law.

I M A E D U C AT I O N A L C A S E J O U R N A L V O L . 8 , N O . 1 , A R T. 1 , M A R C H 2 0 1 57

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