Audio Transcript Of Asset Replacement

What we’re going to do now is look at the way taxes will alter some of your decision making process. In particular we are going to get at the point that in a business context it often makes more sense to replace a perfect well functioning asset in situations where you wouldn’t do it as a private person. So what we’re going to look at here is the purchase of an automobile. And what we’ve done is we’ve said we’re going to buy this $10,000 automobile this is what the cost basis is and what we have here in this column that says ‘Car’ these items right here [B2-B7] is what the cash flow on this replacement automobile would look like from a personal finance point of view. So the idea is you have this perfectly well functioning car what you’re going to do is just replace it with another car that cost $10,000. I know $10000 for a functioning car sounds like a stretch but it makes all the math nice and simple.

Now the first thing we’re going to do is show you that once you jump into a business context there are some other expenses you need to worry about. The reason why there aren’t any other expenses here is it’s assumed that this car that you’re buying has the other same cost characteristic as the other ones and so we are just looking at the change which is the purchase. The next column over (C1-C7) shows the amount of depreciation you have in each year you that own the vehicle. Now it’s assumed that you’re going to keep the vehicle for the entire time. Because it’s an automobile you know it’s a five year asset. This column right here (F1-F7) is that modified accelerated cost recovery (MACRS) table that you’ve seen a couple of times before. In order to get the depreciation each year all your doing is you take a look at the formula here (C2) is taking the cost basis which is $10,000 down here (B10) and multiplying it by that fraction of the cost basis you take this depreciation each year is given in the table. So that first year you get you get $2000 worth of depreciation (C2), the second year you get $3200 depreciation(C3), the third year you get $1920 (C4) and so on down the line. The key thing to remember if you’re using the MACRS tables is that it’s just cost basis times the number in that tables. And if you add all these guys up you are fully depreciating the asset, those all add up to the original $10000. Now again depreciating you know happens when you’re in a business context and because you have depreciation what you have are additional expenses. Even though it is this weird expense that isn’t represented check that is sent to anyone else it still represents an expense which reduces your taxable income. So the idea is that you can take that depreciation expense and say ah-ha! this is how much my taxable income will fall by.

Now in order to get at what your tax rate is suppose to be I’ve gone ahead and created a couple of tax scenarios here. What we did is we said well this is going to be a large corporation, this is going to be a corporation that has a 35% federal tax rate(B13) and at the same time we’ve situated this guy in Oregon and gave it a 7.7% tax rate (B14). So this car actually represents represent a really small change that this business is thinking about making and what we’re actually looking at here is how that cash flows change when you go ahead and make this one small purchase. What I’ve created here (B15) is that federal and state tax rate, I’ve stuck them together in order to get the combined tax rate. What you’re doing in that case is just taking the sum of the state and federal tax rate and just subtracting off the product and that’s what you should see there. So its just .35 plus .077 less the product of.35 and .077 [(.35+.077-(.35*.077)) in other words (B13+B14-(B13*B14))]. So this tax savings that we will eventually get up to right here (D2) is simply that increase in depreciation and that increase in expense times the tax rate. So what this represents is in each year because of depreciation how much your taxes go down by. So please note that this is just directly proportionally amounted depreciation. The first year there is quite a bit of reduction in taxes because of depreciation the second year it goes up and then after that it goes on down. Well what I’m doing with the next column (E) is I’m saying well this is going to alter our cash flow and so what I’m going to have here in this column (E) is this after tax cash flow. What we’re doing here is we are adding in the cash flow you see from over here (Column B) which is kind of that pre-tax or what it would look like from a personal point of view and then adding in the tax savings. So if you see the first year that you purchased the vehicle while originally in this pre-tax sense, in this personal sense you’re going to see a $10,000 reduction in cash flow that particular year. You see that the reduction in class flow is a little bit small on this $9,199. Well what’s interesting is that every year thereafter because you purchased the vehicle you’re having depreciation, and because you have depreciation your taxable income is down, and because your taxable income is down your taxes are down. So ever year thereafter you actually have a positive cash flow from buying this asset.

Now in order to show you how it is that this personal point of view is different from the business point of view I’ve given you a minimal acceptable rate of return (MARR) here (B11) of 5% so we can start looking at the present worth of these two assets. Now we’re brining everything back to year one and so from a personal point of view replacing your car is just simple it’s just the cash that you paid for it, $10,000, you don’t have any tax savings so that’s all that you have. But what this number right here (E8) represents and again what I’ve done is I’ve created the net present value of that stream of benefits and costs. The net present value in a business context is something which is a little closer to a positive infinity. What your seeing is that these folks, because you’re in a business context have a present value of that cash flow of only negative $6,326 as opposed to the (negative)$10,000 that you have on a personal finance basis. This means on a personal finance basis in order to warrant replacing an existing vehicle you have to come with $10,000 worth of benefits, whether that’s $10,000 of you really like the feel of leather seats, whether it $10,000 of sunroof that you want to have, is it $10,000 of heated seats? You’ve got to come up with $10,000 in order to make that financial leap to replace an existing vehicle. But in a business context you only have to come up with $6,326 worth of benefits because there’s already some built in because of the tax savings. So if you’re going to have slightly higher sales or something along those lines this starts to make sense.
So the main thing I want to get across here is that in a business context your often going to find that you replace vehicles at a much faster rate than you do in a personal context. Now if you think about this you’ve seen it happen before you have tool in your garage that maybe are second generation tools, when you go to….[End]

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