Question

Macon Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 3 years ago at a cost of $90,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 6 more years. The new assembly line costs $120,000; requires $9,000 in installation costs and $5,000 in training fees; it has a 6-year usable life and would be depreciated under the straight-line method. The new assembly line will increase output and thereby raises sales by $10,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $15,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $10,000. At the end of 6 years, the existing assembly line is expected to have a market value of $4,000; 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.

1. What is the initial cash outlay for this replacement project?

2. What is the operating cash flow of the project?

3. What is the terminal cash flow of the project?

4. Should you replace the existing assembly line? Provide all the details.

Please give the explanation and formula!

Answer 1

Ans.

Current Book value of old machine
= Cost x Remaining life / Useful life
= $90,000 x 6 / 9
= $60,000

Sales value = $15,000

Loss on sale = $60,000 - $15,000 = $45,000

Sales value net of tax
= Sales value + Tax benefit
= $15,000 + (Loss x Tax rate)
= $15,000 + ($ 45,000 x 20%)
= $ 24,000

Net Initial investment
= All costs of new machine - Sales value net of tax of old machine
= $134,000 - $ 24,000 = $110,000

Out of this, $80,000 will be borrowed and rest of the money will be funded by equity shareholders.

Cost of debt after-tax = 10% x (100 - Tax) = 10% x 80% = 8 %

Cost of equity = 10%

So,

Weighted average cost of capital or WACC
= 8% x 80,000 / 110,000 + 10% x 20,000 / 110,000
= 7.64%

Extra benefits of the new line = $15,000

Increase in working capital investment
= Increase in receivables - Increase in payables
= $10,000 - $ 5,000 = $ 5,000

Incremental depreciation
= (Cost of new line - Current book value of old line) x 1/6
= (134,000 - 60,000) / 6
= $12,333.33

Incremental salvage value net of tax
= Difference of salvage value x (100 - Tax)
= (15,000 - 4,000) x 80% = $ 8,800

1.What is the initial cash outlay for this replacement project?

Initial outlay
= Net Initial investment + Working capital investment
= $110,000 + $5,000 = $115,000

2. What is the operating cash flow of the project?

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	$	$	$	$	$
Net Benefits		$ 15,000.00	$ 15,000.00	$ 15,000.00	$ 15,000.00	$ 15,000.00	$ 15,000.00
Less: Depreciation	-	$(12,333.33)	$(12,333.33)	$(12,333.33)	$(12,333.33)	$(12,333.33)	$(12,333.33)
Total Benefits	-	$    2,666.67	$    2,666.67	$    2,666.67	$    2,666.67	$   2,666.67	$    2,666.67
Tax @ 20%	-	$      (533.33)	$      (533.33)	$      (533.33)	$      (533.33)	$      (533.33)	$      (533.33)
Benefits after tax	-	$    2,133.34	$    2,133.34	$    2,133.34	$    2,133.34	$   2,133.34	$    2,133.34
Add: Depreciation	-	$ 12,333.33	$ 12,333.33	$ 12,333.33	$ 12,333.33	$ 12,333.33	$ 12,333.33
Add: Salvage Value net of tax	-	-	-	-			$    8,800.00
Less: Cost of asset	$(110,000.00)	-	-	-	-
Less: Working Capital	$     (5,000.00)	-	-	-	-
Add: Working Capital Released	-	-	-	-			$    5,000.00
Annual Cash Flows	$(115,000.00)	$ 14,466.67	$ 14,466.67	$ 14,466.67	$ 14,466.67	$ 14,466.67	$ 28,266.67

3. What is the terminal cash flow of the project?

Terminal cash flow = Salvage value net of tax + Working capital released = $ 8,800 + $5,000 = $13,800

4.Should you replace the existing assembly line?

Years	Total Benefits/ (Outflow) (a)	Discounting Factor @ 7.64% (b ) = (1/1+r)^n	P.V. (c ) = (axb)
0	$   (115,000.00)	1	$(115,000.00)
1	$      14,466.67	0.929022668	$    13,439.86
2	$      14,466.67	0.863083118	$    12,485.94
3	$      14,466.67	0.801823781	$    11,599.72
4	$      14,466.67	0.744912468	$    10,776.40
5	$      14,466.67	0.692040569	$    10,011.52
6	$      28,266.67	0.642921376	$    18,173.24
	SUM (NPV)		$   (38,513.32)

NPV = Present value of cash inflows - initial investment of the project.

The machine line should not be replaced as the NPV is negative.