Question

2. Lolonyo Company is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The new grinder costs GHs 105,000 and requires GHs 5,000 in installation costs; it has a 5-year usable life and would be depreciated under MACRS using a 5-year recovery period. The cost of the existing machine was 70,000 and it was being depreciated under the 5-year recovery period. The existing machine has been in use for the past 3 years and Lolonyo can currently sell the existing grinder for GHs 7,000 without incurring any removal or clean-up costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by GHs 40,000, inventories by GHs 30,000, and accounts payable by GHs 58,000. At the end of 5 years the new grinder would be sold to net GHs 29,000 before taxes. The firm is subject to a 40% tax rate. The estimated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the following table.
Year New Grinder (GHS) Existing Grinder(GHS)

1           83,000                          23,000
2           93,000                          23,000
3           73,000                          23,000
4           63,000                          23,000
5           53,000                          23,000

Use the Table containing the applicable MACRS depreciation percentages below

Table containing the applicable MACRS depreciation percentages.
Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property classes

Percentages by Recovery year

Recovery
Year           2 year 5 Year 7 Year 10 Years 1                    33.            20.        14              10
2                     45.           32.         25.             18
3                     15.            19.         18.             14
4                      7.             12.         12.             12
5.                                      12.        9.                9
6                                      5          9.                8
7                                                9.                7
8                                                4.                6
9                                                                 6
10                                                                  6
11                                                                4


Required:
(a) Calculate the initial investment associated with the replacement of the existing grinder by the new one.

(b) Determine the incremental operating cash inflows associated with the proposed grinder replacement.

(c) Determine the terminal cash flow expected at the end of year 5 from the proposed grinder replacement.

(d) Apply the Net Present Value (NPV) and the Internal Rate of Return ((IRR) rules to assess the viability or otherwise of the proposed replacement project.

Answer 1

(a) Calculate the initial investment associated with the replacement of the existing grinder by the new one.

New grinder costs GHs 105,000 and requires GHs 5,000 in installation costs = GHs 110,000

Accounts receivable would increase by GHs 40,000, inventories by GHs 30,000, and accounts payable by GHs 58,000; Therefore Increase inWorking Capital = 40,000 + 30,000 - 58,000 = GHs 12,000

Income by selling old grinder = GH 7,000

Since there has been no capital gains, capital gains tax won't be applicable

Therefore Net Investment = 110,000 + 12,000 - 7,000 = GHs 115,000

(b) Determine the incremental operating cash inflows associated with the proposed grinder replacement.

3) Terminal Cash Flow in Year 5 = > Operating Cach Flow + Selling Price of Grinder - Capital Gains Tax + Recovery of Working CApital = 36840 + 29000 - 9500 + 12000 = 68340

(d) Apply the Net Present Value (NPV) and the Internal Rate of Return ((IRR) rules to assess the viability or otherwise of the proposed replacement project.