Question

accounting quiz

Let say that samo   Company is considering the purchase of a newer, more efficient yogurt-making machine. If purchased, it would require the new machine on January 2, year 1. samo   expects to sell 600,000 gallons of milk in each of the next five years at a $2 per gallon selling price.

samo   has two options:

(1) continue to operate the old machine purchased four years ago or

(2) sell it and purchase the new machine.

The following information has been prepared to help decide which option is more desirable.

Old Machine New Machine Original cost of machine at acquisition $ 1,600,000 $ 2,000,000 Useful life from date of acquisition 7 years 5 years Expected annual cash operating expenses:    Variable cost per gallon $1.20 $1.00    Total fixed cash costs $ 400,000 $ 160,000 Estimated cash value of machines follows: Old Machine New Machine January 2, Year 1 $ 400,000 $ 2,000,000 December 31, Year 3 $200,000 0 December 31, Year 5       0                 $500,000

samo   is subject to a 40% income tax rate on all income. Assume the company uses the straight-line method for books and tax purposes. Assume that tax depreciation is calculated without regard to salvage value. Use an after-tax discount rate of 10%.

Answer 1

Replacement Decisions

Decision regarding replacement of an existing asset with another is based on the net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and the periodic net cash flows if the asset is replaced.

Calculating periodic cash flows of existing asset is straight forward. Since the existing asset is already purchased, the initial investment outlay is zero and the periodic net cash flows are calculated based on the following formula:

Net cash flows = (revenue – operating expenses – depreciation) * (1 – tax rate) + depreciation

If the asset is replaced, it involves investment is the new asset and sale or disposal of the existing asset. Disposal of exiting asset has some income tax implications which need to be reflected in the calculation of initial investment as follows:

Initial investment after replacement = cost of new asset - sale proceeds of old asset +/- tax on disposal

Tax on disposed asset = (sale proceeds of old assets – book value of old asset) * tax rate

Incremental cash flows

Particulars	Old Machine	New Machine
Capital Investment	$                                -	$                    20,00,000
Revenue	$                     12,00,000	$                    12,00,000
Operating cost	$                     11,20,000	$                      7,60,000
Annual depreciation	$                       1,33,333	$                      3,00,000
Net cash flows	=(1200000-11200000-133333)*(1-.40)+133333	=(1200000-760000-400000**)*(1-.40)+300000
	$                     1,01,333	$                    3,24,000

Note - In tax depreciation is taken without salvage in new machine, see workings. In the old machine salvage is taken as Nil, hence both depreciation is same. But in considering incremental cash flows.. the value of depreciation is taken from $4,00,000 fro life of balance 3 years - see workings.

REPLACEMENT DECISION
Capital Investment	$                     20,00,000
Sale proceeds of old Machine	$                       4,00,000
Net investment after replacement *** (Workings)	$20,00,000 - $4,00,000+114286* =           $ 17,14,286
Net investment before replacement	0
Net investment after replacement - Net investment before replacement	=17,14,286-0
Incremental cash flow at time 0	$                     17,14,286
Incremental cash flow in year 1 to 5	$                       2,22,667
Factor @ 10% for 5 years	3.7907
PV of incremental cash flow year (1 to 5)	$                       8,44,063
Net Present Value =	=844063-1714286
Formula = PV of incremental cash flow year (1 to 5) - Increment - initial investment	$                   (8,70,223)

Hence Net present value is negative, replacement decision is not advisable.

Workings:-

Gain/Loss of sale of old machine - year 4
Cost of investment		$                    16,00,000
Less- Depreciation for 4 years	=228571*4	$                     (9,14,284)
Closing value of machine at end of year 4		$                      6,85,716
Sale Value of old machine on sale at year 4		$                     (4,00,000)
Loss on sale of machine		$                      2,85,716
Tax savings on loss ***	=285716*40/100	$                    1,14,286

Workings - Depreciation
Depreciation of old machine	=1600000/7
	$                       2,28,571
Depreciation of old machine after 4 years	=400000/3
	$                       1,33,333
Depreciation of new machine	=(2000000-500000)/5
	$                       3,00,000
Depreciation of new machine without salvage	=(2000000)/5
	$                       4,00,000