Question

B Company is considering replacing an existing processor with a new one that costs $240,000. Shipping and setup costs for the new processor are estimated.to be $13,000. B Company's working capital is expected to increase by $15,000 when the new processor begins operation and is expected to be fully recoverable at the end of the project. The new processor's useful life is expected to be 5 years and its salvage value at that point is estimated to be $49,900. The old processor had an installed cost of $120,000 when it was placed in service three years ago and is being depreciated to a zero book value using a 5 year ACRS life. The processor can be sold today for $33,200. The increase in revenues and before tax cash operating expenses for the new processor compared to continuing with the old processor are shown in the table below. B Company has a marginal tax rate of 34% and a cost of capital of 10%.

Year	Incremental Revenues	Incremental Cash Operating Expenses	ACRS Depr. %
1	$80,000	$22,000	15
2	$79,000	$21,000	22
3	$91,000	$30,000	21
4	$88,000	$25,000	21
5	$88,000	$28,000	21

The initial investment for the project is:

$231,295

$223,876

$224,266

$228,952

The installed cost of the new processor is:

$207,000

$228,000

$253,000

$238,000

Incremental depreciation expense for year 2 in the life of the new processor is:

$34,120

$31,680

$32,900

$30,460

Operating Cash Flow After Tax (OCFAT) for year 3 of the life of the new processor is:

$58,324

$54,074

$63,106

$43,448

After tax salvage value of the new processor at the end of year 5 is:

$32,934

$37,545

$29,641

$36,886

Operating cash flow after tax (OCFAT) for year 5 of the life of the new processor is

$99,011

$105,598

$102,305

$103,622

NPV of the project is:

$129

$122

$103

$110

Answer 1

Depreciation table for the old processor:

Formula	Year (n)	0	1	2	3	4	5
	Depreciation rate ('r)		15%	22%	21%	21%	21%
Initial cost of old processor*r	Depreciation (D)		18,000	26,400	25,200	25,200	25,200
	Book value	120,000	102,000	75,600	50,400	25,200	-
	Book value at the end of year 3				50,400
	Salvage value				33,200
	Tax on gain				(5,848)
	After-tax salvage value				39,048

NPV calculation:

Formula	Year (n)	0	1	2	3	4	5
Purchase price + shipping & setup cost	Initial equipment cost (Ec)	(253,000)
	Increase in NWC (Inwc)	(15,000)
	After-tax salvage value of old processor (ASV)	39,048
(-Ec - Inwc + ASV)	Initial investment (II)	(228,952)
	Incremental revenues (IR)		80,000	79,000	91,000	88,000	88,000
	Incremental Op. expenses (IC)		(22,000)	(21,000)	(30,000)	(25,000)	(28,000)
	Depreciation rate ('r)		15%	22%	21%	21%	21%
r*Ec	Depreciation (D)		(37,950)	(55,660)	(53,130)	(53,130)	(53,130)
Year 4 and Year 5 depreciation from the depreciation schedule of the old processor	Saving on depreciation of old processor (D1)		25,200	25,200
IR -IC -D	EBIT		45,250	27,540	7,870	9,870	6,870
34%*EBIT	Tax @ 34%		(15,385)	(9,364)	(2,676)	(3,356)	(2,336)
EBIT-Tax	Net income		29,865	18,176	5,194	6,514	4,534
	Add: depreciation (D)		37,950	55,660	53,130	53,130	53,130
Net income + D	Operating Cash Flow (OCF)		67,815	73,836	58,324	59,644	57,664
	Recovery of NWC						15,000
Salvage value*(1-Tax rate)	After-tax salvage value of new processor (ASV1)						32,934
OCF + Recovery of NWC + ASV1 - II	Free Cash Flow (FCF)	(228,952)	67,815	73,836	58,324	59,644	105,598
1/(1+d)^n	Discount factor @ 10%	1.000	0.909	0.826	0.751	0.683	0.621
FCF*Discount factor	PV of FCF	(228,952)	61,650	61,022	43,820	40,738	65,568
Sum of all PVs	NPV	43,846

1). Initial investment of the project = 228,952

2). Installed cost of the new processor = 253,000

3). Incremental depreciation expense for Year 2 = depreciation expense for the new processor - depreciation expense for the old processor = 55,660 - 25,200 = 30,460

4). OCFAT for year 3 = 58,324

5). After-tax salvage value of the new processor = 32,934

6). OCFAT for year 5 = 105,598

7). Project NPV = 43,846 (Please check the given options for the NPV. It is not so low as those given in the options.)