Question

3. Woodland Corporation purchased a printing machine three (3) years ago and is considering replacing it with a new one which is faster and easier to operate. The old machine has been depreciated over 3 years using straight line depreciation. Its original installation cost was $15,000. The old machine has been in use for 2 years, and it can be traded in for $3,500. The new machine will be purchased $24,000 and it will also be depreciated over 3 years using the straight line method. It is not expected to have a residual value. Net working capital will decrease because supply levels can be reduced by $1,500. Revenues will increase by $5,000 every year, it will result in laborsavings of $3,000 per year due to its greater speed. Reducing training expenses are expected to save an additional $2,500 per year. The firm is in the 20% tax bracket. Required: i. Calculate the operating cash flows from years 1 to 3. ii. What is the terminal year non‐operating cash flow?

Answer 1

i. Calculate the operating cash flows from years 1 to 3.

Net increase (decrease) in operating revenue
- Net (increase) decrease in operating expenses, excluding depreciation
= Net incremental operating cash flow before taxes
- Net (increase) decrease in income taxes on operating cash flow
= Net incremental operating cash flow after taxes
+ Depreciation tax shield: net increase (decrease) in depreciation expense for
tax purposes × tax rate
= Incremental net cash flow for the period

in here we only take relevant information for calculation of operating cash flows from 1 st year to 3rd year

so the equation is gave in the table

Operating Cash flow from 1st year to 3rd year

	Year 1	Year 2	Year 3
Net increase in operating revenue	5000	5000	5000
+ Cost saving from labour	3000	3000	3000
+ Cost saving from training expenses	2500	2500	2500
= Net incremental operating cash flow before taxes	10500	10500	10500
- Net increase in income taxes on operating cash flow at rate of 20%	(2100)	(2100)	(2100)
= Net incremental operating cash flow after taxes	8400	8400	8400
+ Depreciation tax shield: net increase (decrease) in depreciation expense for tax purposes × tax rate = 8000 * 20%	1600	1600	1600
= net operating cash flow for the period	10000	10000	10000

Depreciation Scheduel (Straight line) 3 year life

Years	1	2	3
new mechine cost = 24000	24000/3 = 8000	24000/3 = 8000	24000/3 = 8000

old machine are fully depreciated at it its end of 3rd year is the starting of replacement. so there is no effect in depreciation. doesn'n take in to consideration.

What is the terminal year non‐operating cash flow?

Proceeds from sale of asset
+ or - (Taxes on gain) or tax savings on loss from disposal of asset(s)
- Recovered net working capital
= Final year’s incremental net cash flow

There is no salvage value for asset and no carrying value for asset, becuase asset fully depreciated at the end of 3rd year.

That's why there is no gain or loss from disposal of asset.

Recovered net working capital = ( $ 1500)

=terminal year non‐operating cash flow =( $ 1500 )

There is only one item in terminalnon- operating cash flow,That is the recovered net working capital at the end of 3rd year of $ 1500, and it is a cash outflow

>> There is one statement that is The old machine has been in use for 2 years, and it can be

traded in for $3,500.

The sales value, gain from sale of this asset and tax consiqueces are not into consider for this problem. Because it is non operting cash flow in the year of 2nd. In the qustion there is specified that only take operating cash flows from year 1 to 3.

>> Net working capital will decrease because supply levels can be reduced by $1,500

This reduction in net working capital is only taki into consider with inital investment. which means there is release of working capital at the 0th year of project. And it is a inflow of cash at the initial (0th year) time.