Question

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 before tax operating income in the second year of project, T2?

Answer 1

	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( before Tax Incremental Operating Income)		4,500,000	4,500,000	4,500,000
	Incremental Tax on savings @25%		1,125,000	1,125,000	1,125,000
	Incremental Operating 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 Before Tax Incremental Operating Income in Year 2=	$      4,500,000	Ans