Markers Tattoo Studio wants to buy new laser therapy equipment. This new equipment would cost $300,000 to purchase and $20,000 to install. Markers estimates that this new equipment would yield incremental margins of $98,000 annually due to new client services. It would require incremental cash maintenance costs of $10,000 annually. Markers expects the life of this equipment to be 5 years. They estimate a terminal disposal value of $20,000.
Markers has a 25% income tax rate and depreciates assets on a straight-line basis (to terminal value) for tax purposes. The required rate of return on investments is 10%.
Determine the expected increase in annual net income from investing in the new equipment.
Calculate the accrual accounting rate of return based on average investment.
Summarize whether the new equipment is worth investing in from a net present value (NPV) standpoint.
Suppose that the tax authorities are willing to let Markers depreciate the new equipment down to zero over its useful life. If Markers plans to liquidate the equipment in 5 years, should it take this option? Quantify the impact of this choice on the NPV of the new equipment.
Financial Analysis for Markers Tattoo Studio's New Laser Therapy Equipment
Expected Increase in Annual Net Income
1. Incremental Annual Margins: $98,000
2. Less: Incremental Cash Maintenance Costs: $10,000
3. Expected Increase in Annual Net Income: $98,000 - $10,000 = $88,000
Accrual Accounting Rate of Return
1. Initial Investment (Equipment Cost + Installation): $300,000 + $20,000 = $320,000
2. Average Investment ($320,000 / 2): $160,000
3. Annual Accrual Accounting Rate of Return: ($88,000 / $160,000) * 100% = 55%
Net Present Value (NPV) Analysis
1. Calculate Annual Cash Flows:
- Year 1: ($88,000 - $24,500) = $63,500 (after tax)
- Year 2: ($88,000 - $24,500) = $63,500 (after tax)
- Year 3: ($88,000 - $24,500) = $63,500 (after tax)
- Year 4: ($88,000 - $24,500) = $63,500 (after tax)
- Year 5: ($88,000 + $20,000 - $24,500) = $83,500 (after tax)
2. Calculate NPV using the required rate of return of 10%:
NPV = ($63,500 / 1.10) + ($63,500 / 1.10^2) + ($63,500 / 1.10^3) + ($63,500 / 1.10^4) + ($83,500 / 1.10^5) - $320,000
NPV = $57,727.27 + $52,479.34 + $47,708.49 + $43,371.35 + $53,172.97 - $320,000
NPV = $34,459.42
Tax Depreciation and Liquidation Impact on NPV
- If Markers were to depreciate the equipment down to zero over its useful life and then liquidate it in 5 years:- Depreciation per year: ($320,000 - $20,000) / 5 = $60,000
- Tax Shield per year: $60,000 * 25% = $15,000
- Tax Shield over 5 years: $15,000 * 5 = $75,000
- The impact on NPV would be:
NPV with Tax Shield = NPV without Tax Shield + Tax Shield
NPV with Tax Shield = $34,459.42 + $75,000
NPV with Tax Shield = $109,459.42
Conclusion
Investing in the new laser therapy equipment at Markers Tattoo Studio is financially beneficial based on the calculated NPV of $34,459.42 without considering the tax depreciation option. However, if Markers plans to depreciate the equipment down to zero and liquidate it in 5 years to benefit from the tax shield of $75,000, the NPV significantly increases to $109,459.42. Thus, taking the tax depreciation option would further enhance the financial viability of the investment in the new equipment at Markers Tattoo Studio.