Question

duddy kravitz owns the saint viateur bagel store. his world famous bagels are baked in a wood-fired oven that was purchased thirty years ago for $20,000. duddy is considering replacing the old oven with a gas oven, costing $105,000, which would reduce costs by $0.02 per bagel. the store sells 5,000 bagels per day and is open 365 days of the year. the bagels are sold for $0.75 each. the cost of producing each bagel with the wood-burning oven is $0.50. the old oven could be sold today for $5,000 and will be worth $3,000 in two years. the new oven could be sold for $55,000 in two years. assume that the replacement occurs immediately and that sales and production costs occur at the end of the year. assume that both ovens are classified as 10-year property (with depreciation rates of 10% and 18% in the first two years). the business will operate for two years after replacement and then be closed. the tax rate is 35%. what are the terminal year cash flows?

Answer 1

The terminal year cash flows for Duddy Kravitz's bagel store, accounting for savings, sale of new oven, taxes, and depreciation, totals $85,935.

Step-by-step explanation:

To calculate the terminal year cash flows for Duddy Kravitz's bagel store, we need to consider the sale of the new oven, the reduction in operating costs, the salvage value of the old oven, taxes, and depreciation. The annual saving on costs from using the new oven is $0.02 per bagel, and the bagel store sells 5,000 bagels per day for 365 days a year. The tax rate is 35%, which we will apply to the profit increase due to the cost savings.

First, we calculate the annual cost saving: 5,000 bagels/day * 365 days/year * $0.02/bagel = $36,500/year.
Then, we adjust for taxes: $36,500 * (1 - 0.35) = $23,725 after-tax annual savings.
For depreciation, we use the 10-year property rates of 10% and 18% for the first two years.
For the first year, the depreciation of the new oven at 10% would be $105,000 * 0.10 = $10,500.
For the second year, the depreciation at 18% would be $105,000 * 0.18 = $18,900.

In the terminal year (second year), the cash flow includes the after-tax savings for the second year, added to the after-tax salvage value of selling the new oven minus the book value at that time.
The sale of the new oven at the end of year 2: $55,000.
The book value at the end of year 2: $105,000 - ($10,500 +$18,900) = $75,600.
The capital gain on the sale: $55,000 - $75,600 = -$20,600, which is a loss and can reduce taxable income.
The tax shield from the loss: $20,600 * 0.35 = $7,210.
The cash inflow from selling the new oven after taxes: $55,000 + $7,210 = $62,210.
The terminal year cash flow: $23,725 + $62,210 = $85,935.