Question

Central Laundry and Cleaners is considering replacing an existing piece of machinery with a more sophisticated machine. The old machine was purchased 3 years ago at a cost of $ 50, 300 and this amount was being depreciated under MACRS using a​ 5-year recovery period. The machine has 5 years of usable life remaining. The new machine that is being considered costs $ 76,300 and requires $ 3,600 in installation costs. The new machine would be depreciated under MACRS using a​ 5-year recovery period. The firm can currently sell the old machine for $ 55,500 without incurring any removal or cleanup costs. The firm is subject to a tax rate of 40 %The revenues and expenses​ (excluding depreciation and​ interest) associated with the new and the old machines for the next 5 years are given in the table:

(Use the applicable MACRS depreciation​ percentages.)

Note: The new machine will have no terminal value at the end of 5 years.

   New machine           Old machine  
Year   Revenue   Expenses
(excluding depreciation and interest)       Revenue   Expenses
(excluding depreciation and interest)
1   $749,800    $720,300       $674,500   $660,300
2   749,800   720,300       676,500   660,300
3   749,800   720,300       680,500   660,300
4   749,800   720,300       678,500   660,300
5   749,800   720,300       674,500   660,300

a. Calculate the initial investment associated with replacement of the old machine by the new one.

b. Determine the incremental operating cash inflows associated with the proposed replacement.​ (Note: Be sure to consider the depreciation in year​ 6.)

c. Depict on a time line the relevant cash flows found in parts

​(a​) and ​(b​) associated with the proposed replacement decision.

Answer 1

a.Initial investment associated with replacement of the old machine by the new one
Cost of new machine		76300
Add:Installation costs		3600
Total costs		79900
Less: After-tax salvage of old machine:
Cost of Old machine	50300
Less: Accumulated depreciation (20+32+19.2)%*50300	35814
Carrying value of old m/c	14486
Sale value od Old m/c at yr. 3 end	55500
Gain on sale(55500-14486)	41014
Tax on gain(41014*40%)	16406
Net proceeds of sale of Old m/c(55500-16406)		39094
So,initial investment associated with replacement of the old machine by the new one		40806

b. Incremental operating cash inflows associated with the proposed replacement
Year	0	1	2	3	4	5	6
New Machine
1.Revenues		749800	749800	749800	749800	749800
2.Expenses		-720300	-720300	-720300	-720300	-720300
3.Depreciation (20;32;19.2;11.52;11.52;5.76)*79900		-15980.00	-25568.00	-15340.80	-9204.48	-9204.48	-4602.24
4.EBT(1+2+3)		13520	3932	14159.2	20295.52	20295.52	-4602.24
5. Tax at 40%(Row 4*40%)		-5408	-1572.8	-5663.68	-8118.21	-8118.21	1840.896
6. EAT(4+5)		8112	2359.2	8495.52	12177.31	12177.31	-2761.34
7. Add Back depn.(Row 3)		15980	25568	15340.8	9204.48	9204.48	4602.24
8.a.. Operating cash flows(6+7)		24092	27927.2	23836.32	21381.79	21381.79	1840.90
Old Machine:
1.Revenues		674500	676500	680500	678500	674500
2.Expenses		-660300	-660300	-660300	-660300	-660300
3.Depreciation (20;32;19.2;11.52;11.52;5.76)*50300		-10060.00	-16096.00	-9657.60	-5794.56	-5794.56	-2897.28
4.EBT(1+2+3)		4140	104	10542.4	12405.44	8405.44	-2897.28
5. Tax at 40%(Row 4*40%)		-1656	-41.6	-4216.96	-4962.18	-3362.18	1158.912
6. EAT(4+5)		2484	62.4	6325.44	7443.264	5043.264	-1738.37
7. Add Back depn.(Row 3)		10060	16096	9657.6	5794.56	5794.56	2897.28
8.b. Operating cash flows(6+7)		12544	16158.4	15983.04	13237.82	10837.82	1158.91
Incremental operating cash inflows associated with the proposed replacement (8.a.-8.b.)		11548	11768.8	7853.28	8143.968	10543.97	681.98

c. Depiction on a time line the relevant cash flows found in parts a. & b.
Year
0	-40806
1	11548
2	11768.8
3	7853.28
4	8143.968
5	10543.97
6	681.98