Question

Lincon Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 2 years ago at a cost of $105,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 5 more years. The new assembly line costs $150,000; requires $5,000 in installation costs and $4,000 in training fees; it has a 5-year usable life and would be depreciated under the straight-line method. The new assembly line also needs additional piece of land with the current (after-tax) market value of $200,000. The price of the land in 5 years is expected to be $220,000.

The new assembly line will increase output and thereby raises sales by $15,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $55,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $9,000.

At the end of 5 years, the existing assembly line is expected to have a market value of $5,000; the new assembly line would be sold to net $15,000 before taxes. Finally, to install the new assembly line, the firm would have to borrow $80,000 at 10% interest from its local bank, resulting in additional interest payments of $8,000 per year. The firm pays 20% taxes and its shareholders require 10% return.

(A) What is the initial cash outlay for this replacement project?

(B) What is the operating cash flow of the project?

(C)What is the terminal cash flow of the project?

(D) Should you replace the existing assembly line? Provide all the details.

Answer 1

(A) What is the initial outlay associated with this project?

Land cost & survey cost are sunk costs and will not be required for Initial outlay

New assembly line cost = $150,000

Installation costs = $5,000

Training fees = $4,000)

Market value at end of 7 years = $5,000

Annual Dep using SLN on Old Line = Cost/life = $105,000 / 7 = $15,000

Accumulated Dep of existing Assembly line = 2 * $15,000 = $30,000

So Book Value of Old Line = $105,000 - $30,000 = $75,000

Sale proceed of Old Line is $55,000

After Tax Sale value = Sales value – Tax rate * (Sale Value - Book Value)

= $55,000 – 20% ($55,000 – $75,000

= $59,000

Working Capital Released = Increase in A/P - Increase in A/R

= $5,000 - $9,000

= $-4000

So Initial Outlay = -($150,000+ $5,000 + $4,000)+ $59,000 - $4,000 = $104,000

(B) What is the operating cash flow per year?

Interest on Loan is not part of cash flow analysis but will be in P&L statement.

Depreciation on New line using SLN = 128,000 / 5 = $25,600 (159000/5=31800)

	Y0	Year 1	Year 2	Year 3	Year 4	Year 5
Initial Investment	$   (159,000)
Decrease in WC	$        -4,000
After Tax Sale value of Old	$      59,000
Increase in Sales		$ 15,000	$   15,000	$ 15,000	$ 15,000	$ 15,000
Reduction in Prod exp		$   5,000	$     5,000	$   5,000	$   5,000	$   5,000
Less Dep on New Line		$(31,800)	$(31,800)	$(31,800)	$(31,800)	$(31,800)
Add: Salvage of New Line						$ 15,000
Increase in EBT		$ (11,800)	$ (11,800)	$ (11,800)	$ (11,800)	$ 3,200
Less Tax 34%		$   2,360	$   2,360	$   2,360	$   2,360	$ (640)
Net Cash Flows		$ (9440)	$ (9440)	$ (9440)	$ (9440)	$   2,560
Add back Dep		$ 31,800	$ 31,800	$ 31,800	$ 31,800	$ 31,800
OCF	$   (104,000)	$ 22,360	$ 22,360	$ 22,360	$ 22,360	$ 34,360

(C) What is the terminal cash flow?

Terminal Cash Flow at Y5 = $2,560

(D) Find NPV for this project. Should this machine be replaced? Explain why.

NPV = NPV(rate,CF1…Cf5) + CF0 = NPV(10%,22360, 22360 ,22360 ,22360 ,35104)-104,000

= $()

As NPV is negative, Machine shouldn’t be replaced