18.07.2022 - 08:48

# An owner of a large ranch is considering the purchase of a tractor with a front-end loader to clean his corrals instead of hiring workers that do it with a pitch fork. He has given you the following information and has asked you to evaluate this invest

Question:

An owner of a large ranch is considering the purchase of a tractor with a front-end loader to clean his corrals instead of hiring workers that do it with a pitch fork. He has given you the following information and has asked you to evaluate this investment. The equipment costs $40,000. The rancher expects that he will save$11,500 a year that is usually paid to workers that clean out the corral by hand.

However, he will incur an additional cost of $1,000 for fuel, repairs and maintenance. The rancher plans on keeping the equipment for 3 years before replacing it with a new one. He thinks he can sell the old equipment for$25,000 in three years. The rancher anticipates that his marginal tax rate will be 20 percent over the next three years. The IRS will allow the rancher to depreciate the tractor over seven years using the straight-line method. The rancher requires at least a 15% pretax rate of return on capital (pretax).

What is the present value tax savings from depreciation?

• The present value tax savings from depreciation is $2,940. To calculate this, first find the annual depreciation expense:$40,000 / 7 = $5,714.29 Next, calculate the tax savings from depreciation each year:$5,714.29 ? 20% = $1,142.86 Since the rancher plans on keeping the equipment for 3 years and the IRS allows depreciation over 7 years, the tax savings from depreciation for each of the 3 years will be the same:$1,142.86 ? 3 = $3,428.57 To find the present value of these tax savings, you need to discount them back to their present value using the rancher's required pretax rate of return of 15%. The formula to do this is: Present value = Future value / (1 + r)^t Where r is the required rate of return (15%) and t is the number of years. Plugging in the values: Present value =$3,428.57 / (1 + 0.15)^3 = $2,940 Therefore, the present value tax savings from depreciation is$2,940.