Question

HL Construction Co. plans to replace one of its manufacturing equipment for a newer more technology-advance one. The new equipment has a purchase price of $8,000 and will be depreciated as a 7-year class for MACRS. Installation costs for the new equipment are $200. It is estimated that this equipment can be sold in 4 years (end of project) for $5,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new equipment are $4,000 a year. Because of the advance technology of new equipment, there will be a reduction in inventory of $400 today and which will be reverted at the end of the project in year 4.

This existing equipment was purchased 1 year ago at a base price of $3,000. Installation costs at the time for this old equipment were $100. The existing equipment is considered also 7-year class for MACRS. The existing equipment can be sold today for $1,000 and for $0 in 4 years. The company's marginal tax rate is 30% and the cost of capital is 10%.

Answer the 7 questions below.

MACRS Fixed Annual Expense Percentages by Recovery Class

Year        3-Year    5-Year    7-Year    10-Year 15-Year

1              33.33%   20.00%   14.29%   10.00%   5.00%

2              44.45%   32.00%   24.49%   18.00%   9.50%

3              14.81%   19.20%   17.49%   14.40%   8.55%

4              7.41%     11.52%   12.49%   11.52%   7.70%

5                              11.52%   8.93%     9.22%     6.93%

6                              5.76%     8.93%     7.37%     6.23%

7                                              8.93%     6.55%     5.90%

8                                              4.45%     6.55%     5.90%

9                                                              6.56%     5.91%

10                                                           6.55%     5.90%

11                                                           3.28%     5.91%

12                                                                           5.90%

13                                                                           5.91%

14                                                                           5.90%

15                                                                           5.91%

16                                                                          2.95%

For your answer, round to the nearest dollar, do not enter the $ sign, use commas to separate thousands, use a negative sign in front of first number is the cash flow is negative (do not use parenthesis to indicate negative cash flows). For example, if your answer is $3,005.87 then enter 3,006; if your answer is -$1,200.25 then enter -1,200

1. What is today's remaining book value of existing equipment?

2. What is the project's initial cash flows (initial outlay: IO) at Year 0?

3. What is the incremental net operating profit (ΔNOPAT) for Year 4 of this replacement project?

4. What is the incremental cash flow (ΔFCF also known as ΔOCF) for Year 4?

5. What is the cash flow due to tax on salvage value of new equipment at Year 4? If this is a cash outflow put the negative sign (-) in front of the value ** do not use parentheses. If it is a cash inflow, then just enter the number

6. What is the after tax salvage value of the new equipment at Year 4?

7. What is the project's total incremental cash flow for Year 4?

Answer 1

WORKSHEET:
	0	1	2	3	4
Incremental EBITDA		$                 4,000	$            4,000	$               4,000	$              4,000
Incremental depreciation:
Depreciation of new equipment:
MACRS 7 Year depreciation rates		14.29%	24.49%	17.49%	12.49%	Total Depn	Book Value
Depreciation of new equipment:		$                 1,172	$            2,008	$               1,434	$              1,024	$              5,638	$         2,562
Depreciation of old equipment:
MACRS 7 Year depreciation rates [From 2nd year]		24.49%	17.49%	12.49%	8.93%
Depreciation of old equipment		$                     759	$                542	$                   387	$                  277
Incremental depreciation		$                     413	$            1,466	$               1,047	$                  747
Net operating profit [NOI]		$                 3,587	$            2,534	$               2,953	$              3,253
Tax at 30%		$                 1,076	$                760	$                   886	$                  976
Net operating profit after tax [NOPAT]		$                 2,511	$            1,774	$               2,067	$              2,277
Add: Incremental depreciation		$                     413	$            1,466	$               1,047	$                  747
Incremental operating cash flows [OCF]		$                 2,924	$            3,240	$               3,114	$              3,024
-Capital expenditure [Initial outlay-See calculation below]	$                 6,303
-Reinstatement of NWC					$                  400
+After tax cash flow from sale of new machine [see workings below]					$              4,269
-Tax shield on loss on discarding of old equipment = 3100*22.31%*30% =					$                  207
=Annual total project cash flows	$              (6,303)	$                 2,924	$            3,240	$               3,114	$              6,686
ANSWERS:
Remaining book value of existing equipment = 3100-3100*(14.29%) =	$                 2,657
Cost of the new equipment+installation costs = 8000+200 =	$                 8,200
-After tax sale value of the old equipment = 1000+(2657-1000)*30% =	$                 1,497
-Reduction in NWC	$                    400
Project's cash flows (initial outlay) at Year 0	$                 6,303
EBIT in year 4 [See Worksheet given above]	$                 4,000
NOPAT+Incremental depreciation in year 4 [See Worksheet above}	$                 3,024
Cash flow due to tax on salvage value of new equipment at Year 4 = (5000-2562)*30% =	$                    731
After tax salvage value of the new equipment at Year 4 = 5000-731 =	$                 4,269
The project's total incremental cash flow for Year 4	$                 6,686