Question

A firm is considering the replacement of its existing machine with new automated machinery costing $850,000. The new machine will lead to an increase in cash sales of $280,000 p.a. Annual interest expense will increase from $15,000 to $25,000.

Annual cash operating expenses are currently $300,000 and will decrease by $60,000 with the new machine. The new machine has a five-year life for tax purposes and for internal management accounting the firm assumes all non-current assets have a ten-year tax life.

The firm will sell its existing machine for $73,000 today and this machine is being depreciated at $23,000 p.a. over its remaining five-year life. Assume the company tax rate is 30%.

What are the 'cash flows over the life'?

Answer 1

We are given.

Cost of new automated machine =  $850,000.

Life of new Machine = 5 Yrs

Depreciation =  Cost of Machine / Life of Machine = 850,000 / 5 = $ 170,000

Book Value of the Existing Machine = Depreciation * Remaining Life = 23,000 * 5 = $115,000

Selling Price of Existing Machine = $73,000

As Book Value is higher than the selling price, there will be no tax for selling the old machine.

Cash flow in Yr 0 = - Cost of New Machine + Selling Price of Existing Machine = - 850,000 + 73,000 = -777,000

Increase in Sales = $280,000

Increase in Interest expense = 25,000 - 15,000 = $10,000

Change in Operating Cost = - 60,000

Net Operating Cash Flow each Year =  Increase in Sales - ( Incremental Increase expense + Decrease in Operating Cost)

= + 280,000 - ( 10,000 - 60,000)

= $330,000

Depreciation will be charged for the First Five Years

EBT (Earning before Tax) = Net Operating Cash Flow each Year - Depreciation

Tax Payment = Tax Rate *  EBT (Earning before Tax) = 30% * EBT (Earning before Tax)

Operating Cash Flow = Net Operating Cash Flow each Year -  Tax Payment

Showing the cash flows over the years in excel,

Cost of new machine	-850000
Sale of old machine	73000
Year	0	1	2	3	4	5	6	7	8	9	10
Increase in sales		280000	280000	280000	280000	280000	280000	280000	280000	280000	280000
Increase in interest rate		10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000
Dec in Operating cost		60,000	60,000	60,000	60,000	60,000	60,000	60,000	60,000	60,000	60,000
Net cash flow		3,30,000	3,30,000	3,30,000	3,30,000	3,30,000	3,30,000	3,30,000	3,30,000	3,30,000	3,30,000
Depreciation		1,70,000	1,70,000	1,70,000	1,70,000	1,70,000
EBT		1,60,000	1,60,000	1,60,000	1,60,000	1,60,000	3,30,000	3,30,000	3,30,000	3,30,000	3,30,000
Tax		48000	48000	48000	48000	48000	99000	99000	99000	99000	99000
Operating cash flow	-777000	2,82,000	2,82,000	2,82,000	2,82,000	2,82,000	2,31,000	2,31,000	2,31,000	2,31,000	2,31,000

Hope this helps.

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