Question

Adam Smith is considering automating his pin factory with the purchase of a $475,000 new machine having a $30,000 salvage value in replacement of the old machine. Shipping and installation would cost $6,000. The old machine was originally purchased for $200,000. It is sold with a market value of $300,000. The old machine has depreciated book value of $150,000 and zero salvage value. The pin factory requires an additional working capital of $80,000. The machine has a useful life of 4 years The firm's marginal tax rate is 40 percent. The maintenance cost is expected to occur every year at $70,000. The new machine is expected to produce a revenue of $500000 for the first year. Revenues are to be increased by 11% every year. A. Calculate depreciation of old and new machines as well as incremental depreciation? B. Estimate the relevant cash inflows for four years?

Answer 1

Depreciation of Old and New Machine:

New Machine:

Purchase Price = $475,000

Incidental Costs (Shipping and Installation Costs) = $6,000

Total Cost of the new machine = $475,000 + $6,000 = $481,000.

Salvage Value of new machine = $30,000

Useful Life of new machine = 4 years

Deperciation =

Deperciation = = 112,750

Deperciation for new machine is $112,750 per annum.

Old Machine:

Purchase Price = $200,000

Incidental Costs (Shipping and Installation Costs) = $0

Total Cost of the new machine = $200,000 + $0 = $200,000.

Salvage Value of new machine = $0

Useful Life of new machine = 4 years

Deperciation =

Deperciation = = $50,000

Deperciation for old machine is $50,000 per annum.

Incremental Deperciation = Deperciation on new machine - Deperciation on old machine

Incremental Deperciation = $112,750 - $50,000 = $62,750.

Incremental deperciation by replacing new machine with old machine is $62,750 p.a.

Relevant cash inflows (Outflows) for 4 years:

Year 1:

Purchase of new machine = ($475,000)

Shipping and Installation charges = ($6,000)

Sale of Old Machine = $300,000

Additional investment in working capital = ($80,000)

Revenues = $500,000

Maintainence Cost = ($70,000)

Taxes =

Taxes = ($500,000 - ($70,000 + $112,750)) * 0.4 = ($126,900)

Total Cash Inflows = -475,000 -6,000 + 300,000 - 80,000 + 500,000 - 70,000 -126900 = $42,100

Total Cash Inflows for Year 1 is $42,100

Year 2:

Revenues = $555,000 (After increasing by 11% from 500,000)

Maintainence Cost = ($70,000)

Taxes =

Taxes = ($555,000 - ($70,000 + $112,750)) * 0.4 = ($148,900)

Total Cash Inflows = 555,000 - 70,000 -148,900 = $336,100

Total Cash Inflows for Year 2 is $336,100

Year 3:

Revenues = $616,050 (After increasing by 11% from 555,000)

Maintainence Cost = ($70,000)

Taxes =

Taxes = ($616,050 - ($70,000 + $112,750)) * 0.4 = ($173,320)

Total Cash Inflows = 616,050 - 70,000 -173,320 = $372,730

Total Cash Inflows for Year 3 is $372,730

Year 4:

Revenues = $683,815.5 (After increasing by 11% from 616,050)

Maintainence Cost = ($70,000)

Taxes =

Taxes = ($683,815.5 - ($70,000 + $112,750)) * 0.4 = ($200,426.2)

Total Cash Inflows = 683,815.5 - 70,000 -200,426.2 = $413,089.3

Total Cash Inflows for Year 4 is $413,089.3