Question

In: Finance

The Rauzi Company is looking to replace an existing computer system with a new, more efficient...

The Rauzi Company is looking to replace an existing computer system with a new, more efficient system. They feel the new will increase cash flow.

The new system will cost $435,000 today and have a 4 year production life. It will be depreciated using 100% bonus depreciation with an estimated salvage value of $175,000 at the end of its production life. The project will also set aside $15,000 for working capital.

The old computer is currently two years old and had an estimated production life of six years. It originally cost $305,000 and was depreciated using 100% bonus depreciation. It could be sold for $150,000 today and we estimated that if kept, we would sell it for $25,000 at the end of its production life.

The new is estimated to produce revenue of $250,000 per year and have expenses of $75,000 per year (excluding taxes) for its production life. The old was expected to produce revenue of $135,000 per year and have expenses of $85,000 per year (excluding taxes) for its production life.

Rauzi has a 30% tax rate and requires a 20% return on this investment. Use NPV and determine if they should invest. SHOW ALL WORK!

Solutions

Expert Solution

The Rauzi Company should invest in new system since NPV of the replacement decision is positive.

Working Notes:

Step 1: Incrimental initial flow
a)the cost of new asset $    435,000.00
Add: working capital on new asset $      15,000.00
Out flow $    450,000.00
Less: Salvage value of old asset after taxation today $    168,500.00
Less: Recapture of WC on old asset $                     -  
Incremental flow $    281,500.00

Step 2:

Incremental inbetween flow
Particulars Year 0 Year 1 Year 2 Year 3 Year 4
Initial Investment $    281,500.00
EBDT of New System $        175,000.00 $    175,000.00 $       175,000.00 $       175,000.00
EBDT of old System $          50,000.00 $      50,000.00 $         50,000.00 $          50,000.00
Incremental EBDT $        125,000.00 $    125,000.00 $       125,000.00 $       125,000.00
Depreciation of New System $          65,000.00 $      65,000.00 $         65,000.00 $          65,000.00
Depreciation of Old System $          46,666.67 $      46,666.67 $         46,666.67 $          46,666.67
Incremental Depreciation $          18,333.33 $      18,333.33 $         18,333.33 $          18,333.33
Incremental EBIT $        106,666.67 $    106,666.67 $       106,666.67 $       106,666.67
Less Income tax @ 30% $          32,000.00 $      32,000.00 $         32,000.00 $          32,000.00
Profit After Tax $          74,666.67 $      74,666.67 $         74,666.67 $          74,666.67
Add: Incremental Depreciation $          18,333.33 $      18,333.33 $         18,333.33 $          18,333.33
Cash flow After Tax $          93,000.00 $      93,000.00 $         93,000.00 $          93,000.00
Step 3: Terminal Flow
Salvage value of new asset after taxation $       175,000.00
Add: Recapture on working capital on new assets $          15,000.00
Less salvage value of old asset after taxation -terminal flow $          25,000.00
Less Recapture of WC on old asset $                          -   $                     -   $                         -   $                         -  
Total Free Cash flow $ (281,500.00) $          93,000.00 $      93,000.00 $         93,000.00 $       258,000.00

Consolidation of Step 1 to Step 3

Year CFAT PVF @ 20% DCF
0 $ (281,500.00)                      1.000 $     (281,500.00)
1 $      93,000.00                      0.833 $          77,500.00
2 $      93,000.00                      0.694 $          64,583.33
3 $      93,000.00                      0.579 $          53,819.44
4 $    258,000.00                      0.482 $       124,421.30
Total $          38,824.07
Present Value of Inflow = $       320,324.07
Present Value of Outflow = $       281,500.00
NPV = PVI - PVO 320324.07-281500
NPV = $         38,824.07
Depreciaiton calculation of new machine
Year Cost Depreciation Book Value Method
1 $      435,000.00        65,000.00 $ 370,000.00 Staight Line
2 $      370,000.00        65,000.00 $ 305,000.00 Staight Line
3 $      305,000.00        65,000.00 $ 240,000.00 Staight Line
4 $      240,000.00        65,000.00 $ 175,000.00 Staight Line
Sales Value of new machine      175,000.00
Book Value $ 175,000.00
Profit                        -  
Tax @ 30%                        -  
Sales Value of new machine after tax      175,000.00
Depreciaiton calculation of old machine
Year Cost Depreciation Book Valuue Method
1 $      305,000.00        46,666.67 $ 258,333.33 Staight Line
2 $      258,333.33        46,666.67 $ 211,666.67 Staight Line
3 $      211,666.67        46,666.67 $ 165,000.00 Staight Line
4 $      165,000.00        46,666.67 $ 118,333.33 Staight Line
5 $      118,333.33        46,666.67 $    71,666.67 Staight Line
6 $        71,666.67        46,666.67 $    25,000.00 Staight Line
Salvage value of old asset today $ 150,000.00
Book value after 2 years $ 211,666.67
Profit / Loss on sale $ (61,666.67)
Tax @ 30% $ (18,500.00)
Salvage value of old asset after tax $ 168,500.00
Salvage value of o

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