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.

(A) (9 points) What is the initial cash outlay for this replacement project?

(B) (3 points) What is the operating cash flow of the project?

(C) (5 points) What is the terminal cash flow of the project?

(D) (3 points) Should you replace the existing assembly line? Provide all the details.

Answer 1

Purchase Price of old machine = $90,000

Useful life = 6 years

Depreciation per year for the old machine = 90,000/6 = 15,000

Book value of the machine at the end of 3rd year = 90000 - 15000*3 = 90000 - 45000 = 45,000

Solution a) Initial Cash Outlay = FCInv + NWCInv - Sal0 + t(Sal0 - BV0)

FCInv = New machine investment = 120,000 + 9000 = $129,000

NWCInv = Increase in Working Capital Investment = Increase in Account Receivable - Increase in Accounts Payable

= 10000 - 5000 = $5,000

Sal0 = Current Salvage value of existing machine = 15000

t = tax rate = 20%

Initial Cash Outlay = 129,000 + 5,000 - 15,000 + 20%*(15000 - 45000)

= 129,000 + 5,000 - 15,000 + 20%*(-30000)

= 129,000 + 5,000 - 15,000 - 6,000

= 113,000

Solution b) Annual After-Tax Operating Cash Flow (CF) = (S - C)(1 - t) + t*D

CF = Incremental after-tax operating Cash Flow

S = Incremental Sales

C = Incremental Costs

D = Incremental Depreciation

New Depreciation = 129000/6 = 21500

CF = (10000 - (-5000))*(1 - 20%) + 20%*(21500 - 15000)

= 15000*80% + 20%*(6500)

= 12000 + 1300

= 13,300

Solution c) Terminal Cash flow of the project (TNOCF) = SalT + NWCInv - t(SalT - BT)

SalT = Incremental Salvage Value over Old Machine = 15000 - 4000 = 11000

NWCInv = Recovery of additional investment in net working capital = 5000

t*(SalT - BT) = Incremental cash flow from taxes on gains on disposal

= 20%*(15000 - 0) - 20%*(4000 - 0)

= 20%*15000 - 20%*4000

= 3000 - 800

= $2,200

TNOCF = 11000 + 5000 - 2200 = $13,800

Solution d) The cash flows are as follows:

Since, the NPV is negative, so, the replacement should not be done.

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