Question

Top Cat Ltd is a company that supplies pet food to the dogs and cats of Australia. The company’s

marginal tax rate is 30%. The business is considering replacing a five-year-old manually operated

tuna processing machine that originally cost $100,000, presently has a book value of $50,000, and

could be sold for $120,000. This machine is currently being depreciated using the straight-line

method down to a terminal value of zero over the next five years, generating depreciation of

$10,000 per year. The fully automated replacement machine would cost $250,000, have a five-

year expected life over which it would be depreciated down using the straight-line method, and

have no salvage value at the end of five years.

Other information:

• The new machine would produce power savings before depreciation and taxes of $90,000 per year.
• Installation charge for the new machine is $10,000.
• Investment in inventories needs to be increased by $20,000.
• The old machine was operated by one operator who earned $30,000 per year.
• Annual cost of maintenance with the old machine was $10,000 per year.
• Annual cost of maintenance with the new machine is expected to be $40,000 per year.
• The required rate of return is 10% per year.
• A preliminary feasibility study incurred sunk costs of $5,000.

Required

a      Calculate the initial investment associated with the replacement project.

2. Calculate the incremental operating net cash inflows associated with the proposed replacement machine.

c      Determine the terminal cash flow expected from the proposed machine replacement.

d      Calculate the pay-back period of the proposed replacement machine.

e      Calculate the net present value of the proposed replacement machine.

Answer 1

a)	Cost of the new machine		$ 2,50,000
	Installation cost		$ 10,000
	Total cost of the new machine		$ 2,60,000
	Sale value of the old machine	$     1,20,000
	Book value of the old machine	$        50,000
	Gain on sale	$        70,000
	Tax on gain at 30%	$        21,000
	After tax salvage value = 120000-21000 =		$ 99,000
	Net cost of replacement of machine		$ 1,61,000
	Add: Increase in NWC		$ 20,000
	Initial investment		$ 1,41,000
b)
	Savings in power	$        90,000
	Savings in operating and maintenance cost = 40000-(30000+10000) =	$                  -
	Incremental depreciation = 260000/5-10000 =	$        42,000
	NOI	$        48,000
	Tax at 30%	$        14,400
	NOPAT	$        33,600
	Add: Depreciation	$        42,000
	Incremental OCF	$        75,600
c)	Recapture of NWC	$        20,000
	Terminal cash flow	$        20,000
d)	Payback period = Initial investment/Annual OCF
	= 141000/75600 =	1.87	Years
e)	PV of OCF = 75600*(1.1^5-1)/(0.1*1.1^5) =	$     2,86,583
	PV of terminal cash inflow = 20000/1.1^5 =	$        12,418
	Sum of PV of cash inflows	$     2,99,002
	Less: Initial investment	$     1,41,000
	NPV	$     1,58,002
f)	As the NPV of replacement is positive, the
	proposal can be implemented.