Question

You are the financial manager of this company. The company is considering a replacement project for an old overhead crane. The old crane is was purchased 5-years go and and originally cost $90,000. It had a useful life of 10-years and is being depreciated on a straight-line basis. The new crane would cost $300,000 and would require an additional $15,000 in net working capital (recovered at the end of year 5). It would be depreciated straight-line over the next 5 years. The new crane would have lower operating costs of $63,000 per year for the next 5 years. The old crane can be sold now for $20,000. The new crane is expected to have a salvage of $35,000 at the end of 5 years. The relevant tax rate is 30% The initial outlay, ongoing cash flows and terminal cash flow of this replacement decision

Answer 1

Answer : Initial Outlay Calculation :

Initial Outlay = Initial Cost of Machine + Increase in Net working Capital - Sale proceeds of Old machine - Tax on Loss of Sale of Old Machine

Tax on Loss of Sale = (Book Value of Old Machine - Sale Value ) * Tax Rate

Book Value = 90000 - [(90000 /10) * 5]

= 90000 - 45000

= 45000

Tax on Loss of Sale = (45000 - 20000 ) * 30%

= 7500

Initial Outlay = 300000 + 15000 - 20000 - 7500

= -287500

Ongiong Cash Flow = Saving in after tax Operating Cost + Tax Shield on Additinal Depreciation .

Assuming Saving in Operating Cost is before Tax

Saving in Operating Cost = 63000 * (1 - 0.30) = 44100

Tax Shiel on Additioanl depreciation = [New Depreciation - Old Depreciation] * Tax Rate

= [(300000 / 5) - (90000 / 10)] * 30%

= 15300

Ongiong Cash Flow = 44100 + 15300 = 59400

Terminal cash Flow = After Tax Sale proceeds + Recovery of working Capital

After Tax sale Proceedas = Sale Value * (1 - Tax rate)

= 35000 * (1 - 0.30)

= 24500

Terminal cash Flow = 24500 + 15000 = 39500