Question

3. Blue Ocean Tech currently operates with a unit it purchased four years ago. The unit which originally cost $530,000 currently has a book value of $90,100. (There are 2 years of depreciation remaining using the MACRS rates below). Blue Ocean is considering replacing the machine with a newer more efficient one. The new unit will cost $650,000 and will require an additional $35,000 for delivery and installation. The firms expects to be able to reduce net operating working capital by $22,000 when the machine is installed, but required working capital will be returned to the original level when the machine is sold after 5 years (and no other changes are expected each year). Blue Ocean expects to be able to sell the existing unit now for $230,000 and their marginal tax rate is 40%. The new unit will be depreciated using the MACRS 5 year investment class (20%, 32%, 19%, 12%, 11%, and 6% for years 1 through 6 respectively).

            If Blue Ocean purchases the new unit, annual revenues are not expected to change, however, annual operating costs (exclusive of depreciation) are expected to decrease by $24,000.   The annual revenue and costs are expected to remain at these levels for 5 years. After 5 years, the new unit is expected to be sold for $140,000 and if kept, the existing unit will have a book value of zero and could be sold for $40,000.

A) (8 points) Calculate the year 0 cash flow

B) (9 points) Calculate the terminal value in year 5 and include the return of NOWC to original levels.

C) (8 points) Calculate the year 1 operating cash flow

Answer 1

A]	Cost of the new machine including costs for delivery and installation = 650000+35000 =		$   6,85,000
	Sale value of the old machinery [at t0]	$      2,30,000
	Less: Book value	$         90,100
	Gain if sold at t0	$      1,39,900
	Tax at 40% on gain	$         55,960
	After tax sale value of old machine = 230000-55960 =		$   1,74,040
	Net cost of machinery		$   5,10,960
	Less: Reduction in net working capital		$       22,000
	Year 0 Cash outflow		$   4,88,960
B]	After tax sale value of the old machinery [at t5] = 40000*(1-40%) =		$       24,000
	Sale value of the new machinery	$      1,40,000
	Book value = 685000*6% =	$         41,100
	Gain on sale	$         98,900
	Tax at 40% on gain	$         39,560
	After tax sale value of the new machinery = 140000-39560 =		$   1,00,440
	Incremental after tax sale value of machinery = 100440-24000 =		$       76,440
	Less: Increase [restoration of] NOWC		$       22,000
	After tax terminal cash inflow		$       54,440
C]		0	1	2	3	4	5
	Savings in operating costs		$       24,000	$       24,000	$      24,000	$        24,000	$       24,000
	Incremental depreciation:
	Depreciation of new machine		$   1,37,000	$   2,19,200	$   1,30,150	$        82,200	$       75,350
	Depreciation of old machine		$       58,300	$       31,800
	Incremental depreciation		$       78,700	$   1,87,400	$   1,30,150	$        82,200	$       75,350
	Incremental NOI		$     -54,700	$ -1,63,400	$ -1,06,150	$      -58,200	$      -51,350
	Tax at 40%		$     -21,880	$     -65,360	$     -42,460	$      -23,280	$      -20,540
	Incremental NOPAT		$     -32,820	$     -98,040	$     -63,690	$      -34,920	$      -30,810
	Add: Incremental depreciation		$       78,700	$   1,87,400	$   1,30,150	$        82,200	$       75,350
	Incremental operating cash inflows		$       45,880	$       89,360	$      66,460	$        47,280	$       44,540
			Year 1 OCF