Question

1. Existing machine was purchased 2 years ago at a cost of $3,200. It is being depreciated straight line over its 8 year life. It can be sold now for $3,000 or used for 6 more years at which time it will be sold for an estimated $500. It provides revenue of $5,000 annually and cash operating costs of $2,000 annually. A replacement machine can be purchased now for $7,800. It would be used for 6 years, and depreciated straight line. It will result in additional sales revenue of $1,500 annually, but because of its increased efficiency it would reduce cash operating costs by $600 per year. The new machine would require additional inventories of $700, and accounts receivable would increase by $300. Its expected salvage value in 6 years is $2,000.

The tax rate is 40% and the required rate of return is 13%. Should the old machine be replaced?

a. Calculate the incremental cash flow at time 0 (ie the initial cost of this replacement project). [5marks]

b. Calculate the incremental annual operating cash flows that result from the new machine. [5marks]

c. Calculate the incremental terminal cash flow. [5marks]

Answer 1

a]	Cost of the replacement machine		$       7,800
	Sale value of the old machine	$        3,000
	Book value of the old machine	$        2,400
	Gain on sale	$           600
	Tax on gain at 40%	$           240
	After tax sale value = 3000-240 =		$       2,760
	Net replacement cost		$       5,040
	Increase in NWC = 700+300 =		$       1,000
	Incremental cash flow at time 0		$       4,040
b]	Addl. Sales revenue from new machine	$        1,500
	Reduction in operating costs	$           600
	Incremental depreciation = 1300-400 =	$           900
	Incremental NOI	$        1,200
	Tax at 40%	$           480
	Incremental NOPAT	$           720
	Add: Depreciation	$           900
	Incremental annual operating cash flow	$        1,620
c]	After tax salvage value of new machine = 2000*(1-40%) =	$        1,200
	Less: After tax salvage value of old machine = 500*(1-40%) =	$          -300
	Incremental salvage value	$           900
	Recapture of NWC	$        1,000
	Incremental terminal cash flow	$        1,900
d]	PV of annual operating cash flows = 1620*(1.13^6-1)/(0.13*1.13^6) =	$        6,476
	PV of salvage value = 1900/1.13^ 6 =	$           913
	Sum of PV of cash inflows	$        7,389
	Less: Initial investment	$        4,040
	NPV	$        3,349
e]	As the NPV is positive, the old machine can be
	replaced.