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

Cost of New Machine =  $850,000.

Life of Machine for tax purposes = 05 Years

Depreciation each Year =  Cost of New Machine / Life of Machine = 850,000 / 05 = $ 170,000

Book Value of the Existing Machine = Depreciation each year of old m/c  * Remaining Life

= 23,000 * 05 = $ 115,000

Selling Price of Existing Machine = $ 73,000

Since Book Value Higher Than Selling Price, there will be no tax for selling old machine.

So Cash flow for Year 0 = - Cost of New Machine + Selling Price of Existing Machine = - 850,000 + 73,000 = -777,000

Increase in Sales each Year due to New Machine = + 280,000

Incremental Increase in Interest Rate = 10,000

Decrease in Operating Cost = - 60,000

Net Operating Cash Flow each Year =  Increase in Sales each Year due to New Machine - ( Incremental Increase in Interest Rate + Decrease in Operating Cost) = + 280,000 - ( 10,000 -60,000) = 330,000

Now Depreciation will be charge for First Five Year Only.

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

Ans :

cash flows over the life' of machine :

Year	1	2	3	4	5	6	7	8	9	10
cash flows	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