Question

Company Y's management is evaluating a piece of machinery that costs $1.5 million. This machine will replace an existing, old machine that is fully depreciated (book value is zero) and could be sold today for $500,000. The old machine could continue operating for another 10 years at which time it would have no salvage value.

The new machine has the same production capacity as the old machine, but operating costs will be lower each year by $200,000. The new machine will require an additional $100,000 in increased working inventory for its operations. The new machine is expected to have a life of 10 years. It is to be depreciated fully (down to zero) over ten years, using the straight line method. It will have no salvage value at the end of 10 years.

Company Y is profitable and expects to continue paying taxes at 35%.

6. The time-zero cash flow from replacing the old machine with the new machine is a net outflow of

7. The recurring annual cash flow from replacing the old machine with the new machine is a net inflow of

8. In addition to the recurring annual cash flow, if we replace the old machine with the new one then in year 10 there is incremental inflow of

Answer 1

6. time-zero net cash outflow = cost of new machine - after-tax salvage value of old machine + investment in increased working inventory

after-tax salvage value of old machine = salvage value - [(salvage value - book value)*tax rate] = $500,000 - [($500,000 - $0)*35%] = $500,000 - $500,000*35% = $500,000 - $175,000‬ = $325,000‬

time-zero net cash outflow = $1,500,000 - $325,000 + $100,000 = $1,275,000‬

7. The recurring annual cash flow from replacing the old machine with the new machine is a net inflow of [(operating costs savings - depreciation)*(1-tax rate)] + depreciation = $182,500.

[($200,000 - $1,500,000/10)*(1-0.35)] + $1,500,000/10 = [($200,000 - $150,000)*0.65] + $150,000 = ($50,000‬*0.65) + $150,000 = $32,500‬ + $150,000 = $182,500‬.

8. In addition to the recurring annual cash flow, if we replace the old machine with the new one then in year 10 there is incremental inflow of $100,000 from recovery of investment in increased working inventory.