In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1. The following information is being considered by Gunning Industries:
* The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.
* The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs include $30 per unit in variable costs and total fixed costs of $40,000 per year.
* The investment in the new machine will require an immediate increase in working capital of $35,000. This cash outflow will be recovered after 5 years.
* Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of 5 years and zero salvage value.
* Gunning is subject to a 40% corporate income tax rate. Gunning uses the net present value method to analyze investments and will employ the following factors and rates:
The acquisition of the new production machine by Gunning Industries will contribute a discounted net-of-tax contribution margin of
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Correct Answer:
D
The new machine will increase sales by 20,000 units a year. The increase in the pretax total contribution margin will be $200,000 per year [20,000 units x ($40 SP --- $30 VC)], and the annual increase in the after tax contribution margin will be $120,000 [$200,000 x (1.0--- .4)]. The present value of the after-tax increase in the contribution margin over the 5-year useful life of the machine is $454,920 ($120,000 x 3.791 PV o f an ordinary annuity for 5 years at 10%).
