Question

ABC Gas industries is considering a replacement of an old petroleum refining machine (model 16) acquired 4 years ago with costs of:

Purchasing price                     450,000

Shipping & Handling costs    10,000

Installation cost                      15,000

The new model 107 will be acquired at costs of

Purchasing price                     750,000

Shipping & Handling costs    20,000

Installation cost                      30,000

The new model will result in cost savings of 50,000 annually during years 1 to 4, 20,000 annually in the next 5 years and 10,000 annually during the last 2 years. The old model could be sold at his fair market value $240,000. ABC Gas industries tax rate is 36% and cost of capital is 16%.

REQUIRED

a.Model 16 Book Value

b.Gain or loss on the sale of Model 16

c.Tax benefit or tax obligation on the sale

d.Cash flow from the sale of model 16

e.Initial investment (net investment) in acquisition of model 107

f.Incremental depreciation year 2 and year 6

g.Total net benefits or net cash flows year 3 and year 7

h.Net present value of the replacement decision

i.Is the replacement a good decision?

Answer 1

	Model 16
	Particulars	Amount in $
	Purchase Price	$450,000
	Shipping & Handling cost	$10,000
	Installation cost	$15,000
	Book value on the date of Purchase	$475,000
	It is assumed that the Life of Model 16 is 12 Years i.e same as the life of New Model 107
	Depreciation per year =	Book Value of the Asset/ Life of the Machine
		($475000/12)
	Depreciation per year of Model 16	$39,583.33
	No of Years completed	4
	Depreciation provided as on the decission to sale	Depreciation per year * No of Years completed
		39583.33*4 years
	Depreciation per 4 Years	$158,333.32
1	Net Book value	Book value - Depreciation for 4 years
		$ 475000 - $ 158333.22
		$316,666.78
2	Gain/Loss on sale of Model 16	Net Book value - sale proceeds
	Net Book value	$316,666.78
	Expected Sale Procceds	$240,000
	Loss on sale of Old Model	$ 240000-$316666.78
		($76,666.78)
3	Tax benefit / Tax obligation on sale	Since there is a loss on sale of Old Model there will be a tax benefit
	Loss on sale of Old Model	($76,666.78)
	Tax rate	36%
	Tax benefit =	Loss on sale * Tax %
		$76666.78*36%
		$27,600.04
4	Cashflow from sale of Model 16	I.e expected procceds from sale of Model 16
		i.e $ 240,000
5	Initial Investment in acquisition of Model 107
	Particulars	Amount in $
	Purchase Price	$750,000
	Shipping & Handling cost	$20,000
	Installation cost	$30,000
	Book value on the date of Purchase (A)	$800,000
	Less: Expected sale proceeds from Sale of Old Model 16 (B)	($240,000)
	Net Initial Investment on acquisition of Model 107 (A+B)	$560,000