Question

Macon Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 3 years ago at a cost of $90,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 6 more years. The new assembly line costs $120,000; requires $9,000 in installation costs and $5,000 in training fees; it has a 6-year usable life and would be depreciated under the straight-line method. The new assembly line will increase output and thereby raises sales by $10,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $15,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $10,000. At the end of 6 years, the existing assembly line is expected to have a market value of $4,000; the new assembly line would be sold to net $15,000 before taxes. Finally, to install the new assembly line, the firm would have to borrow $80,000 at 10% interest from its local bank, resulting in additional interest payments of $8,000 per year. The firm pays 20% taxes and its shareholders require 10% return.

(A) (9 points) What is the initial cash outlay for this replacement project?

(B) (3 points) What is the operating cash flow of the project?

(C) (5 points) What is the terminal cash flow of the project?

(D) (3 points) Should you replace the existing assembly line? Provide all the details.

Please provide equations and more details, thank you very much!

Answer 1

.

Current Book value of old machine
Current Book value of old machine  = Cost * Remaining life / Useful life
Current Book value of old machine = $90,000 x 6 / 9
Current Book value of old machine  = $60000

.

Sales value = $15,000

Loss on sale = $60,000 - $15,000 = $45,000

Sales value net of tax = Sales value + Tax benefit
= $15,000 + (Loss x Tax rate)
= $15,000 + (45,000 x 20%) = 15000 + 90000
Sales value net of tax  = $24000

.

Net Initial investment = All costs of new machine - Sales value net of tax of old machine

All costs of new machine = 120000 + 9000 + 5000 = 134000
Net Initial investment  = 134000 - 24000 = $110000

.

>> Out of this, $80,000 will be borrowed and rest of the money will be funded by equity shareholders.

Cost of debt after-tax = 10% x (100 - Tax) = 10% x 66% = 6.6%

Cost of equity = 10%

So,

Weighted average cost of capital or WACC
WACC = ( 6.6% x 80,000 / 110000 )+ ( 10% x 30000 / 115000 )

WACC = 4.80 + 2.73
WACC = 7.53%

..

Extra benefits of the new line = $15,000.00  (increase in sales by 10000 plus decrease in cost by 5000 )

.

Increase in working capital investment
= Increase in receivables - Increase in payables
= 10000 - 5000 = 5000

.

.

Incremental depreciation = (Cost of new line - Current book value of old line) / Useful life
Incremental depreciation  = (134000 - 60000) / 6
Incremental depreciation  = $12333

.

Incremental salvage value net of tax
= Difference of salvage value x (100 - Tax)

Difference of salvage value = 15000 - 4000 = 11000
= 11,000 x 66% = $7,260

.

Now, let's assemble all the information in a table.

Question A)

Initial outlay
= Net Initial investment + Working capital investment
= $110000 + $5000 = $115000

.

Question B)

Operating Cash flows of the project are:

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	$	$	$	$	$
Net Benefits		15,000	15,000	15,000	15,000	15,000	15,000
Less: Depreciation	-	12333	12333	12333	12333	12333	12333
Total Benefits	-	2,667.00	2,667.00	2,667.00	2,667.00	2,667.00	2,667.00
Tax Exp @ 20%	-	533.4	533.4	533.4	533.4	533.4	533.4
Earning after tax		2133.6	2133.6	2133.6	2133.6	2133.6	2133.6
Add: Depreciation	-	12,333.00	12,333.00	12,333.00	12,333.00	12,333.00	12,333.00
Operating cash flow		14,466.60	14,466.60	14,466.60	14,466.60	14,466.60	14,466.60
Add: Salvage Value net of tax	-	-	-	-			7260
Less: Cost of asset	-1,05,000.00	-	-	-	-
Less: Working Capital	-5,000.00	-	-	-	-
Add: Working Capital Released	-	-	-	-			5000
Annual Cash Flows	-1,10,000.00	14,466.60	14,466.60	14,466.60	14,466.60	14,466.60	26726.60

Question C)

Terminal cash flow = Salvage value net of tax + Working capital released = $7,260 + $5,000 = $12260

Question D)

NPV of the project @ 7.53% is:

Years	Cash flow inflow / (Outflow) (a)	Discounting Factor (b ) = (1/1+r)^n = ( 1 / 1 + 7.53%)^n	P.V. (c ) = (axb)
0	-110000.00	1	-1,10,000.00
1	14,466.60	0.92997	13,453.50
2	14,466.60	0.86485	12,511.44
3	14,466.60	0.80429	11,635.34
4	14,466.60	0.75796	10,965.10
5	14466.60	0.69559	10,062.82
6	26726.60	0.64688	17,288.90
.	SUM (NPV)	.	-34,082.89

.

* The machine line should not be replaced as the NPV is negative.