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 5 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 5.

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 5 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 5 of this replacement project?

4. What is the incremental cash flow (ΔFCF also known asΔOCF) for Year 5?

5. What is the cash flow due to tax on salvage value of new equipment at Year 5? 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 5?

7. What is the project's total incremental cash flow for Year 5?

Answer 1

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

.

Acquisition cost of existing equipment = purchase cost 3000 + installation cost 100 = 3100

Accumulated Depreciation under MACRS for two year

Just prepare MACRS Depreciation table for existing equip.

Years	cost	MACRS rate	depreciation	Accumulated depreciation
1	3100	14.29%	442.99	442.99
2	3100	24.49%	759.19	1202.18
3	3100	17.49%	542.19	1744.37
4	3100	12.49%	387.19	2131.56
5	3100	8.93%	276.83	2408.39
6	3100	8.93%	276.83	2685.22
7	3100	8.93%	276.83	2962.05
8	3100	4.45%	137.95	3100

.

Today is the Beginning of first year life of existing equipment and the old equip. Depreciated for 1 years

Accumulated depreciation on end of 1^st year of existing equip. Life = 442.99

Book value of existing equipment = Acquisition cost of existing equipment - Accumulated depreciation on end of 1^st year of existing equip. Life

.

Today's remaining book value of existing equipment = 3100 - 442.99 = 2657

.

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

.

Purchase cost = -$8000

Add: installation cost = -$200

= Total cost of acquisition of new equip. = -$8200

Less: reduction in work in capital = 400

Less: Net Proceeds from existing equip. = 1497*

= Initial outlay = -$6303

.

*Calculation of Net Proceeds from existing equip.

Market value = $1000 ( inflow)

Carrying Book value = 2657

Taxable Loss on sale = 1657

Tax benefit from loss = 898 * 30% = 497 (inflow)

Net Proceeds from existing equip. = 1000 + 497   = 1497 (inflow)

.

.

3 .What is the incremental net operating profit (ΔNOPAT) for Year 5 of this replacement project?. = $2481

.

net operating profit (NOPAT)

EBITDA	$4000
Less: Incremental depreciation	455.43*
Earnings Before Tax	3544.57
Less: Tax expenses @30%	1063.37
NOPAT	2481

.

*incremental depreciation

Depreciation under MACRS for new equipment at year 5 = Cost of equip. * MACRS rate for year 5

.

Cost of equip. = 8200

MACRS rate for year 5 = 8.93%

Depreciation under MACRS for new equipment at year 5 = 8200 * 8.93% = 732.26

Less: Depreciation Under MACRS for existing equipment at year 5 (project year, which is 6^th year of old equip. ) , if it exist = 276.83

incremental depreciation = 732.26 - 276.83 = 455.43

.

4. What is the incremental cash flow (ΔFCF also known asΔOCF) for Year 5?   = $2536

.

NOPAT	2481
Add: Incremental depreciation	455.43
Less: Reverted inventory	-$400
ΔOCF	$2536

.

.

5. What is the cash flow due to tax on salvage value of new equipment at Year 5?

.

Salvage value = 5000

Book value of new equip. = Acquisition cost - Accumulated depreciation

Acquisition cost = 8200

Accumulated depreciation at end of 5 year = 6370.58* (see in the below table)

.

Years	cost	MACRS rate	depreciation	Accumulated depreciation
1	8200	14.29%	1171.78	1171.78
2	8200	24.49%	2008.18	3179.96
3	8200	17.49%	1434.18	4614.14
4	8200	12.49%	1024.18	5638.32
5	8200	8.93%	732.26	6370.58
6	8200	8.93%	732.26	7102.84
7	8200	8.93%	732.26	7835.1
8	8200	4.45%	364.9	8200

.

Carrying value = Acquisition cost - Accumulated depreciation at end of 5 year = 8200 - 6370.58 = 1829.42

Salvage value = 5000

Taxable gain from sale = 5000 - 1829.42 = 3170.58

Tax expenses on gain = 3170.58 * 30% = -$951

.

cash flow due to tax on salvage value of new equipment at Year 5 = -$951

.

6. What is the after tax salvage value of the new equipment at Year 5?

.

Salvage value = 5000

Less: Tax expenses on gain from sale = 951

After tax salvage value of the new equipment at Year 5 = 5000 - 951 = $4049

.

7. What is the project's total incremental cash flow for Year 5?

.

Answer is sum of answer from question no. 4 and question no. 6

.

ΔOCF	$2536
Add: After tax salvage value	$4049
Total incremental cash flow for Year 5	$6585