Question

A machine currently in use was originally purchased 2 years ago for $40,000.The machine is being depreciated under MACRS using a 5-year recovery period;it has 3 years of usable life remaining. The current machine can be sold today to net $42,000 after removal and cleanup costs.A new machine,using a 3-year MACRS recovery period,can be purchased at a price of $140,000. It requires $10,000 to install and has a 3-year usable life.If the new machine were acquired, the investment in accounts receivable would be expected to rise by $10,000, the inventory investment will increase by $25,000,and accounts payable will increase by $15,000.Profits before depreciation and taxes are expected to be $70,000 for each of the next 3 years with the old machine and $120,000 in the first year and $130,000 in the second and third years with the new machine. At the end of 3 years, the market value of the old machine will equal zero, but the new machine could be sold to net $35,000 before taxes.Both ordinary cororate income and capital gains ate subject to a 40 percent tax..(Table 3.6 on page 91 contains the applicable MACRS depreciation percentages.)

a. Determine the initial investment associated with the proposed replacement decision.

b.Calculate the incremental operating cash inflows for years 1 to 4 associated with the proposed replacement.(Note:Only depreciation cash flows must be considered in year 4.)

c.Calculate the terminal cash flow associated with the proposed replacement decisiong.(Note:This is at the end of year3.)

d.Depict on a time line the relevant cash flows found in a,b, and c associated with the proposed replacement decision assuming that it is terminated at the end of year 3.

Answer 1

a. Assuming General Depreciation System - Straight Line Method under MACRS

Depreciation per year = $40,000/5 = $8,000

Cost of old Machine	$40,000		Purchase price of New Machine	$140,000
Sale Value	42000		Add:- Installation Cost	$10,000
Book Value after 2 years	$24,000		Total Cost of New Machine	$150,000
40000- 8000-8000
Gain on sale of Old machine	18000
42000-24000
Tax to be paid on Gain	7200
18000*0.40
Net Gain on sale of Old Machine	10800

Net Initial Investment	$139,200
150,000 - 10,800

Therefor Net Initial Investment with the Replacement Decision is $139,200

b. Assuming Installation Cost has been Capitalised

Depreciation per year for New Machine = $150,000/3 = $50,000

PAT with Old Machinery	PAT with New Machinery	Incremental Cash Flow
Year	PAT	Depreciation	Cash Flow	Year	PAT	Depreciation	Cash Flow
1	70000	8000	78000	1	120000	50000	170000	92000
2	70000	8000	78000	2	130000	50000	180000	102000
3	70000	8000	78000	3	130000	50000	180000	102000

For Year 4 Book Value of New Machine is 0 but Market Value is $ 35,000 . Hence Net Cash Flow in Year 4 after deducting taxes = 35,000 - 40% of 35000 = 35,000 - 14,000 = $21,000

c. The Terminal Cash Flow at Year 4

For Year 4 Book Value of New Machine is 0 but Market Value is $ 35,000 . Hence Net Cash Flow in Year 4 after deducting taxes = 35,000 - 40% of 35000 = 35,000 - 14,000 = $21,000