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

Note 1 :

Book value of existing machine : 23000 per year * 5= 115000

Loss on sale of existing machine =Sale value -Book value

                 = 73000 - 115000

                = - 42000

Tax saving due to loss = -42000 * 30%= - 12600

After tax sale value =Sale value - Tax saving

               = 73000 - (-12600)

              = 73000 +12600

              = 85600

Working Note 2:

Depreciation on new machine =Cost/useful life

           = 850000 /5

           = 170000

CASH FLOW
	0	1	2	3	4	5
Cost of new machine	-850000
After tax sale value of old machine	85600
Increase in cash sales		280000	280000	280000	280000	280000
Increase in interest expense(25000-15000)		-10000	-10000	-10000	-10000	-10000
Saving in operating expense		60000	60000	60000	60000	60000
Depreciation on new machine		-170000	-170000	-170000	-170000	-170000
Income before tax		160000	160000	160000	160000	160000
Tax expense		- 48000 [160000*30%]	-48000	-48000	-48000	-48000
Net income		112000	112000	112000	112000	112000
Add:depreciation		170000	170000	170000	170000	170000
Cash flow	-764400	282000	282000	282000	282000	282000