Question

he Minot Kit Aircraft Company of​ Minot, North​ Dakota, uses a plasma cutter to fabricate metal aircraft parts for its plane kits. The company currently is using a cutter that it purchased four years ago that has a book value of ​$100 comma 000 and is being depreciated ​$25 comma 000 per year over the next 4 years. If the old cutter were to be sold​ today, the company estimates that it would bring in an amount equal to the book value of the equipment. The company is considering the purchase of a new automated plasma cutter that would cost ​$360 comma 000 to install and that would be depreciated over the next 4 years toward a ​$39 comma 000 salvage value using​ straight-line depreciation. The primary advantage of the new cutter is the fact that it is fully automated and can be run by one operator rather than the three employees that are currently required. The labor savings would be ​$70 comma 000 per year. The firm faces an income tax rate of 25 percent. At the end of the​ 4-year project both cutters could be sold at their​ end-of-project book value. a.  What are the differential operating cash flow savings per year during years 1 through 4 for the new plasma​ cutter? b.  What is the initial cash outlay required to replace the existing plasma cutter with the newer​ model? c.  What does the timeline for the replacement project cash flows for years 0 through 4 look​ like? d.  If the company requires a discount rate of 13 percent for new​ investments, should the plasma cutter be​ replaced?

Answer 1

Depreciation on new machine = cost-slavage value/ no. of useful life

=360000-39000/4

=$80250

Statement showing NPV

Particulars	0	1	2	3	4	NPV
Purchase of new automated machine	-360000
Selling price of old machine (Since it is sold at book value itself there will be no tax consequence)	100000
Saving in labour cost		70000	70000	70000	70000
Incremental depreciation( 80250-25000)		55250	55250	55250	55250
PBT		14750	14750	14750	14750
Ta x @ 25%		3688	3688	3688	3688
PAT		11063	11063	11063	11063
Add: Depreciation		55250	55250	55250	55250
Annual cash flow		66313	66313	66313	66313
Salvage value					39000
Total cash flow	-260000	66313	66313	66313	105313
PVIF @ 13%	1.0000	0.8850	0.7831	0.6931	0.6133
PV	-260000	58683.63	51932.41	45957.89	64590.13	-38835.9

Thus

a) Savings from year 1 to 4 are

Particulars	0	1	2	3	4
Annual cash flow		66313	66313	66313	66313

b) Initial cash flow = $260000

d) Since NPV is negative machine should not be replaced