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Green Zebra wants to test out alternative energy for its facilities. It is considering an investment...

Green Zebra wants to test out alternative energy for its facilities. It is considering an investment in a new wind-energy tower with a price of $7million to replace its existing natural gas furnace. Today, the current machine has a book value of $4million and could be sold for $3.5 million. The new machine is expected to have three year life, and the old machine has three years remaining in its economic life. Both machines use straight line depreciation to a zero value at the end of the assets life. If the firm replaces the old machine with the new machine, it expects to save $5.5 million in operating costs before depreciation each year over the next three years. The old furnace will be worth $500,000 at the end of the project life. If the firm purchases the new wind machine, it will also need an investment of $150,000 in net working capital. The required return on the investment is 7 percent, and the tax rate is 25 percent. What is the terminal value associated with the project in T3?

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Expert Solution

Green Zebra
Cash flow details for replacement of NG Furnace All Amt in $
Particulars Year 0 Year 1 Year 2 Year 3
Initial Investent
New Machine         (7,000,000)
Less sales value of old m/c           3,500,000
Investment in NWC            (150,000)
a Total Initial Investment         (3,650,000)
Operating Cash flow
Operating Cost saving pre depreciation           5,500,000           5,500,000           5,500,000
Depreciation on New Machine           2,333,333           2,333,333           2,333,333
Depreciation on old macine           1,333,333           1,333,333           1,333,333
Incremental Depreciation           1,000,000           1,000,000           1,000,000
Net Cost Savings after depreciation           4,500,000           4,500,000           4,500,000
Incremental Tax on savings @25%           1,125,000           1,125,000           1,125,000
Incremental Income post tax           3,375,000           3,375,000           3,375,000
Incremental Depreciation added back           1,000,000           1,000,000           1,000,000
b Operating cash flow           4,375,000           4,375,000           4,375,000
Terminal Cash flow
Net working capital Returned              150,000
Post Tax opportunity loss on salvage value of old machine =500,000*(1-25%)            (375,000)
c Terminal Value            (225,000)
d Total Cash flow =a+b+c         (3,650,000)           4,375,000           4,375,000           4,150,000
So Terminal Value at Yr 3=            (225,000)
Terminal Cash flow at Yr 3=           4,150,000

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