Question

Homework LP10 #11 The question was reviewed and is complete.

The Minot Kit Aircraft Company of​ Minot, North​ Dakota, uses a plasma cutter to fabricate metal aircraft parts for its plane kits. The company currently is using a cutter that it purchased four years ago that has a book value 90,000 and is being depreciated ​$ 22,500 per year over the next 4 years. If the old cutter were to be sold​ today, the company estimates that it would bring in an amount equal to the book value of the equipment. The company is considering the purchase of a new automated plasma cutter that would cost ​$ 340,000 to install and that would be depreciated over the next 4 years toward a ​$ 38,000 salvage value using​ straight-line depreciation. The primary advantage of the new cutter is the fact that it is fully automated and can be run by one operator rather than the three employees that are currently required. The labor savings would be ​$ 70,000 per year. The firm faces an income tax rate of 26 percent. At the end of the​ 4-year project both cutters could be sold at their​ end-of-project book value.

a. What are the differential operating cash flow savings per year during years 1 through 4 for the new plasma​ cutter?

b. What is the initial cash outlay required to replace the existing plasma cutter with the newer​ model?

c. What does the timeline for the replacement project cash flows for years 0 through 4 look​ like?

d. If the company requires a discount rate of 8 percent for new​ investments, should the plasma cutter be​ replaced?

Answer 1

a)	DIFFERENTIAL OPERATING CASH FLOW SAVINGS:	0	1	2	3	4
	Savings in labor per year		70000	70000	70000	70000
	Incremental depreciation:
	New cutter (340000-38000)/4		75500	75500	75500	75500
	Old cutter		22500	22500	22500	22500
	Incremental depreciation		53000	53000	53000	53000
	Incremental NOI		17000	17000	17000	17000
	Tax at 26%		4420	4420	4420	4420
	Incremental NOPAT		12580	12580	12580	12580
	Add: Incremental depreciation		53000	53000	53000	53000
	Incremental OCF		65580	65580	65580	65580
b)	INITIAL OUTLAY FOR THE NEW PLASMA CUTTER:
	Cost of the new cutter	340000
	Less: Sale value of the old cutter	90000
	[No loss or gain on sale as sale value = book value]
	Initial outlay	250000
C)	The time line is given below:
		0	1	2	3	4
		|..........	...........|..........	..........|.........	..........|.........	........|.........
		-$250000	+65680	+65680	+65680	+103580
d)	CALCULATION OF NPV:
	Incremental OCF		65580	65580	65580	65580
	Initial outlay	250000
	After tax salvage value [no gain or loss as MV = BV					38000
	and tax is 0]
	After tax yearly project cash flows	-250000	65580	65580	65580	103580
	PVIF at 8% [PVIF = 1/1.08^n]	1	0.92593	0.85734	0.79383	0.73503
	PV at 8%	-250000	60722	56224	52060	76134
	NPV	-4860
	DECISION:
	THE PLASMA CUTTER SHOULD NOT BE REPLACED AS THE NPV OF THE REPLACEMENT IS NEGATIVE.