Question

Two years ago, Capricorn Inc. purchased an Asset A for $66,000. The asset yields annual operating cash flow of $20,000 for 6 years. The company is now looking into replacing Asset A with Asset B, which will cost $75,000 and yield annual operating cash flow of $40,000 for the next 4 years. Asset A can be sold now for $30,000, but in four years' time, it will only be worth $5,000. Asset B can be sold for $8,000 in four years' time. The required rate of return is 20%. Should Capricorn replace Asset A with Asset B and what probably difference? Ignore taxes.

a.24,185.60

b. 6800.92

c. -27952.31

d. 33003.2

e. 8221.50

Answer 1

(e) 8,221.45

Out of the two options given, we have to find out which gives us more profits.

Alt 1: we continue to use Asset A for another four years

In this case, we do not have any cash outflow today, since we have purchased Asset A two years ago. We now have to find the present value of future cashflows.

Year	Cashflow (1)	Present value factor at 20% (2)	Discouted Cash flow (1) *(2)
1	20,000.00	0.8333	16,666.67
2	20,000.00	0.6944	13,888.89
3	20,000.00	0.5787	11,574.07
4	25,000.00	0.4823	12,056.33
			$ 54,185.96

Note: Year 4 Asset is sold for $5,000. Hence there is cashflow of 20,000+5,000 = $ 25,000

Alt 2 : Here, we sell Asset A and Buy Asset B today, that is at Year 0

Year	Cashflow (1)	Present value factor at 20% (2)	Discouted Cash flow (1) *(2)
0	(45,000.00)	1.0000	(45,000.00)
1	40,000.00	0.8333	33,333.33
2	40,000.00	0.6944	27,777.78
3	40,000.00	0.5787	23,148.15
4	48,000.00	0.4823	23,148.15
			$ 62,407.41

Note : At Year 0, that is today, we sell  Asset A at $ 30,000 and Buy Asset B for $ 75000. So $ 35,000 - $ 75000 = $ (25000)

Note Year 4 Asset B is sold for $8,000. Hence there is cashflow of 40,000+8,000 = $ 48,000

Conclusion :

Cashflow form Alt 1 = $ 54,185.96

Cashflow form Alt 2 = $ 62,407.41

Difference = $8,221.45  

It is advisable to choose alternative 2. Capricorn should replace Asset A with Asset B.