Question

A firm is considering the replacement of its existing machine with new automated machinery costing $850,000. The new machine will lead to an increase in cash sales of $280,000 p.a. Annual interest expense will increase from $15,000 to $25,000.

Annual cash operating expenses are currently $300,000 and will decrease by $60,000 with the new machine. The new machine has a five-year life for tax purposes and for internal management accounting the firm assumes all non-current assets have a ten-year tax life.

The firm will sell its existing machine for $73,000 today and this machine is being depreciated at $23,000 p.a. over its remaining five-year life. Assume the company tax rate is 30%.

What are the 'cash flows over the life'?

Answer 1

All non-current assets have a 10-year life for internal management purposes.

Total cost of existing machine= Depreciation per annum * 10 years= 23000×10 years= $230000

Current book value of existing machine

= Cost- (Annual depreciation ×5 years)

= 230000- 115000= $115000

Sales considerations from disposal of existing equipment= $73000

Loss on disposal= Current book value- sales considerations= 115000- 73000

= $42000

Net proceeds from disposal of old asset

= Sales considerations + Tax benefit on loss= $73000+ (42000* 30%)

= $85600

Net initial investment

= Cost of new machine- Net proceeds from disposal of old asset

= $850000- $85600= $764400

Incremental annual after-tax operating cash flow;

Increase in annual cash sales                                           $280000     

Decrease in annual cash operating expenses                    $60000

Increase in operating cash flow                                        $340000

Tax expenses                  340000*30%                           ($102000)

Incremental annual after-tax operating cash flow        $238000

Interest expense is a financing expense and it will not be considered in an investing decision.

New machine has five-year life for tax purposes.

Depreciation expense for new machine= Cost of the machine/ life of the machine

= $850000/ 5 Years= $170000

Annual incremental depreciation expense

= Depreciation of new machinery- Depreciation of existing machine

= $170000 - $23000= $147000

Annual incremental depreciation tax shield

= Annual incremental depreciation expense * Tax percentage

= $147000* 30%= $44100

Cash flow over the life

Year	Annual incremental operating cashflow (After tax)	Annual incremental depreciation tax shield	Total cashflow
Year 0	Cash outflow for initial investment.	($764400)
Year 1	$238000	$44100	$282,100
Year 2	$238000	$44100	$282,100
Year 3	$238000	$44100	$282,100
Year 4	$238000	$44100	$282,100
Year 5	$238000	$44100	$282,100