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

	a	INITIAL CASH OUTLAY FOR THIS REPLACEMENT PROJECT
	A	Cost of new equipment	$120,000
	B	Installation Cost	$8,000
	C	Trainning Fees	$5,000
	D	Current market Value of old equipment	$15,000
	E	Depreciation of old equipment in first two years	$28,667	(90000-4000/6)*2
	F	Current book value of old equipment	$61,333	(90000-28667)
	G	Loss on sale of old equipment	$46,333	(61333-15000)
	H	Tax savings from sale of old equipment	$9,730	(46333*21%)
	I	Amount of borrowing	$80,000
	J	Increase in New Working Capital	$7,000	(12000-5000)
	K=A+B+C+J-D-H-I	Initial Cash Outlay for replacement project	$35,270
	b	OPERATING CASH FLOW OF THE PROJECT
		INCREMENTAL DEPRECIATION
		Depreciable value of new equipment	$128,000	(120000+8000)
		Estimated Salvage value at end of 4 years	$15,000
		Annual Depreciationof new equipment	$28,250	(128000-15000)/4
		Annual Depreciation of old equipment	$14,333	(90000-4000)/6)
		Incremental annual depreciation	$13,917	(28250-14333)
		Increase in Sales	$10,000
		Decrease in expenses	$5,000
		Increase in annual profit	$15,000
		Less:IncrementalDepreciation	$13,917
		Less: Interest Expenses	$8,000
		Net Increase in annual profit	($6,917)
		Tax Savings due to loss	$1,453	(6917*21%)
		Net after tax Loss per year	($5,464)
		Add: Incremental Depreciation (Non Cash expense)	$13,917
		Operating cash flow of the project	$8,453	(13917-5464)
	c	Terminal Cash Flow of the Project
		Payment of Principal borrowed	($80,000)
		Salvage Value of new equipment	$15,000
		Salvage Value of old equipment	($4,000)
		Release of initial net working capital	$7,000
		Terminal Cash Flow of the Project	($62,000)
	d	Present Value of Cash Flow=(Cash Flow)/(1+i)^N
		i=Required return =10%=0.1
		N=Year of Cash Flow
		N	A	B	C	D=A+B+C	PV=D/(1.1^N)
		Year	Initial Cash Flow	Operating Cash Flow	Terminal Cash Flow	NET CASH FLOW	PRESENT VALUE
		0	($35,270)			($35,270)	($35,270)
		1		$8,453		$8,453	$7,684
		2		$8,453		$8,453	$6,986
		3		$8,453		$8,453	$6,350
		4		$8,453	($62,000)	($53,548)	-$36,574
						SUM	($50,824)
		Net Present Value(NPV) =Sum of PV=	($50,824)
		NO, We should not replace the existing Line
		NPV of the replacement project is negative