Gluon Inc. is considering the purchase of a new high pressure glueball. It can purchase the glueball for $200,000 and sell its old low-pressure glueball, which is fully depreciated, for $36,000. The new equipment has a 10-year useful life and will save $44,000 a year in expenses. The opportunity cost of capital is 8%, and the firm’s tax rate is 40%. What is the equivalent annual savings from the purchase if Gluon uses straight-line depreciation? Assume the new machine will have no salvage value. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
To calculate the equivalent annual savings from the purchase, we need to consider the depreciation, tax savings, and the cost of capital.
1. Depreciation: Given that the new equipment has a 10-year useful life and no salvage value, we can calculate the annual straight-line depreciation as follows:
Annual Depreciation = (Purchase Cost - Sale Price of old equipment) / Useful life
= ($200,000 - $36,000) / 10
= $164,000 / 10
= $16,400
2. Tax Savings: The tax savings arise from the depreciation expense reducing the firm's taxable income. We can calculate the tax savings as follows:
Tax Savings = Depreciation * Tax Rate
= $16,400 * 0.40
= $6,560
3. Cost of Capital: The opportunity cost of capital represents the return the firm could earn by investing the money elsewhere. We can calculate the cost of capital as a percentage of the purchase cost.
Cost of Capital = Purchase Cost * Cost of Capital Rate
= $200,000 * 0.08
= $16,000
4. Equivalent Annual Savings: The equivalent annual savings is the sum of the annual depreciation, tax savings, and cost of capital.
Equivalent Annual Savings = Annual Depreciation + Tax Savings + Cost of Capital
= $16,400 + $6,560 + $16,000
= $39,960
Therefore, the equivalent annual savings from the purchase, using straight-line depreciation, is $39,960.