Question

Macon Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 2 years ago at a cost of $90,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 4 more years. The new assembly line costs $120,000; requires $8,000 in installation costs and $5,000 in training fees; it has a 4-year usable life and would be depreciated under the straight-line method. The new assembly line will increase output and thereby raises sales by $10,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $15,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $12,000. At the end of 4 years, the existing assembly line is expected to have a market value of $4,000; the new assembly line would be sold to net $15,000 before taxes. Finally, to install the new assembly line, the firm would have to borrow $80,000 at 10% interest from its local bank, resulting in additional interest payments of $8,000 per year. The firm pays 21% taxes and its shareholders require 10% return.

Show your work! do not use excel.

(A)     (6 points) What is the initial cash outlay for this replacement project?

(B)      (5 points) What is the operating cash flow of the project?

(C)      (5 points) What is the terminal cash flow of the project?

(D)     (4 points) Should you replace the existing assembly line? Provide all the details.

Answer 1

Year	0	1	2	3	4
Initial cost & installation	-128000
After-tax Training fees(5000*(1-21%)	-3950
After-tax salvage of the existing m/c(as per wkgs.)	24450
Opportunity cost of salvage value lost of the existing m/c(4000*(1-21%)					-3160
After-tax salvage of new m/c(15000*(1-21%))					11850
1.Total Yr. 0 & terminal CAPEX cash flows	-107500	0	0	0	8690
Operating cash flows:
2.Increase in NWC & recovery in Yr.4(12000-5000)	-7000				7000
Incremental sales		10000	10000	10000	10000
Savings in prod. Expenses		5000	5000	5000	5000
Net increase in income		15000	15000	15000	15000
Tax on increased N/Inc.at 21%		-3150	-3150	-3150	-3150
3.EAT		11850	11850	11850	11850
4.Depn. Tax shields lost on exiting m/c(15000*21%)		-3150	-3150	-3150	-3150
5.Depn. Tax shields on new m/c(128000/4*21%)		6720	6720	6720	6720
6.Int.tax shields(8000*21%)		1680	1680	1680	1680
7. Net annual OCFs(2+3+4+5+6)	-7000	17100	17100	17100	24100
8. Total CAPEX & OCFs(1+7)	-114500	17100	17100	17100	32790
9. PV F at 10%(1/1.10^Yr.n)	1	0.90909	0.82645	0.75131	0.68301
10. PV at 10%(8*9)	-114500	15545	14132	12847	22396
11. Ne Present value of the decision(Sum Row 10)	-49579

Workings:
After-tax salvage of the existing m/c
Cost	90000
Acc. Depn.(90000/6=15000*2)	30000
Book value(90000-30000)	60000
Sale value at Yr. 0(given)	15000
Loss on sale(60000-15000)	45000
Tax C/F saved on loss(45000*21%)	9450
After-tax c/F on sale(15000+9450)	24450

ANSWERS: (From the above calculations--

(A)Initial cash outlay for this replacement project

Total Yr. 0 cashflows= -107500

(B)Operating cash flow of the project

Yrs. 0 to 4-- as per Row 7.

-7000; 17100; 17100; 17100 ; 24100

C.Terminal Year cash flow of the project

CAPEX Cah flows= 8690 &

OCF (included in B above)= 24100

Total = 32790

(D) The existing assembly line SHOULD NOT BE REPLACED as the NPV of the new line's cash flows is NEGATIVE as per the above calculations.