Question

Question 6: ABC Co. is considering replacing an old computer with a new one. The old one was purchased 1 year ago for $600,000. It is depreciated strait-line to zero over 6 years. It is expected to be worth $10,000 at the end of its 6-year life. If ABC sells it today, ABC should receive $300,000 for the computer. The new computer costs $750,000. It has a life of 5 years and will be depreciated strait-line to zero over its 5-year life. It is expected to be worthless at the end of its 5-year life. The new generator is expected to reduce the operating costs by $200,000 per year. There is no change in net working capital. The discount rate of this replacement project is 15%, and the tax rate is 40%.   

Year	1	2	3	4	5
Cost Savings
Depreciation
New
Old
Increm. Dep
EBIT
Taxes
NI

Year 0

Cost of new computer =

After-tax cash flows of old computer sale =       

Incremental net capital spending =

Years 1-4

Operating cash flow =

Year 5

Operating cash flow =

After-tax cash flows of old computer sale =

Year	0	1	2	3	4	5
OCF
NCS
DNWC
CFFA

NPV =

Answer 1

Formula	Year (n)	1	2	3	4	5
	Cost savings (CS)	200,000	200,000	200,000	200,000	200,000
	Depreciation:
	New computer (D1)	150,000	150,000	150,000	150,000	150,000
	Old computer (D2)	(100,000)	(100,000)	(100,000)	(100,000)	(100,000)
D1-D2	Incremental depreciation (D)	50,000	50,000	50,000	50,000	50,000
CS - D	EBIT	150,000	150,000	150,000	150,000	150,000
EBIT*40%	Tax @ 40%	60,000	60,000	60,000	60,000	60,000
EBIT-Tax	Net income (NI)	90,000	90,000	90,000	90,000	90,000

Capital spending calculation:

Formula		Year 0	Year 5
	Cost of new computer (Cn)	7,50,000
Original cost - depreciation expense	Book value of old computer	5,00,000	0
Selling price - (selling price - Book value)*Tax rate	After-tax cash flow of old computer sale (Co)	(3,80,000)	6,000
(Cn-Co)	Incremental net capital spending	3,70,000	(6,000)

Note: Capital spending for Year 0 is for the case when new computer has been bought. Capital spending for Year 5 is for the case when the old computer is not replaced. This is why the incremental net capital spending in Year 5 is negative as for calculating incremental cash flows, the formula is cash flows when old computer is replaced - cash flows when old computer is not replaced.

NPV calculation:

Formula	Year (n)	0	1	2	3	4	5
NI + D	OCF		140,000	140,000	140,000	140,000	140,000
Incremental Net capital spending in Year 0 and Year 5	NCS	(370,000)					(6,000)
No change in NWC	DNWC	-	-	-	-	-	-
OCF - NCS - DNWC	CFFA	(370,000)	140,000	140,000	140,000	140,000	134,000
1/(1+d)^n	Discount factor @ 15%	1.000	0.870	0.756	0.658	0.572	0.497
CFFA*Discount factor	PV of CFFA	(370,000)	121,739.13	105,860.11	92,052.27	80,045.45	66,621.68
Sum of all PVs	NPV	96,318.65