Question

Pinkerton Company is considering acquiring a machine from The Michele Gordigiani Corporation for $720,000. The machine will automate a process currently performed manually. The introduction of the machine will allow Pinkerton to avoid paying annual salaries and benefits over the life of the project, during which salaries and benefits are not expected to grow. No other revenues or expenses will be affected except for those related to the Butterfly Pins (described below). The machine will occupy floor space currently being used to make Butterfly Pins that contribute $120,000 per year to Pinkerton's before-tax cash flow. If Pinkerton acquires the machine from Michele Gordigiani, it would have to discontinue making the Butterfly Pins. Pinkerton has already spent $25,000 to assemble all of the estimates described herein. The project is expected to last for five years. However, the machine must be depreciated by the straightline method over an eight-year life to a zero salvage value for income tax purposes. At the end of the project. Pinkerton expects to be able to sell the machine for $200,000, net of disposal costs. This amount will fall to $50,000 by the end of the eighth year. Required: Assuming that the appropriate after-tax MARR is fifteen percent, what is the minimum amount of equal annual before-tax savings from salaries and benefits that Pinkerton needs in order to justify acquiring the machine from Michele Gordigiani? The relevant income tax rate is 40%.

Answer 1

The student's question relates to determining the minimum annual before-tax savings required from salaries and benefits for Pinkerton Company to justify the acquisition of a machine. It involves capital budgeting, considering depreciation, tax rate, and after-tax MARR. The analysis would establish whether the purchase is financially beneficial.

Step-by-step explanation:

The question involves a capital budgeting decision that Pinkerton Company must make regarding the purchase of a machine that will automate a manual process.

To justify the acquisition, Pinkerton needs to calculate the minimum amount of annual before-tax savings from salaries and benefits that would offset the costs associated with buying the machine and discontinuing the production of Butterfly Pins. Given that the machine costs $720,000, and it replaces labor worth $120,000 per year that was previously contributing to Pinkerton's cash flow, we have to factor in the loss of revenue from discontinuing the Butterfly Pins.

Depreciation of the machine will be over an eight-year life using the straight-line method, resulting in an annual depreciation expense of $90,000 ($720,000 / 8 years). However, the project is only expected to last for five years, after which the machine could be sold for $200,000. The relevant income tax rate is 40%, and the appropriate after-tax minimum attractive rate of return (MARR) is 15%.

When computing the minimum required savings, we must consider the loss of Butterfly Pins income, the depreciation tax shield, the initial cost, the salvage value, and the reduced labor costs. The aim is to find the before-tax savings that will render the net present value (NPV) of the project to be at least zero or positive, thereby meeting the 15% after-tax MARR. The specifics of the cash flow analysis and calculation of the minimum required savings would involve additional information not provided in the question.