Question

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!

Answer 1

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

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