Question

Bellrome Company is planning to replace an old machine with the following related information:
Book value P300,000
Remaining useful life 5 years
Current market value 150,000

Additional information:
 The replacement machine can be acquired at a list price of P500,000. A 5% cash discount is
available if the said machine is paid within 30 days from acquisition date. Freight and installation
costs is estimated at P75,000.
 Should the company decide not to acquire the new machine, it needs to repair the old one at a cost
of P50,000. Otherwise, additional cost of removing the old unit is estimated at P10,000.
 Additional gross working capital of P15,000 will be needed to support operation planned with the
new equipment.
 The new machine is estimated to reduce cash operating costs amounting to P150,000 per year
and is to be depreciated using the straight-line method over its useful life of 5 years.
 Bellrome is subject to a 30% income tax rate.

REQUIREMENTS:
a. What is the net initial cost of investment to be used in decision making?
b. What is the increase in annual net income?
c. What is the increase in annual net cash flows if the company replaces the machine?

Answer 1

a) Net cost of Investment

List price of the Asset                                    = P 500,000

Add :Freight & Installation =  P 50,000

          Cost of removing Old Asset = P 10,000

Less: Cash Discount ( Note 1)                     = (P 25,000)

Depreciable value of Asset                      = P 535,000

Less : Sale value of Old Asset after tax      = (P 105,000)

Add : Working capital requirement =  P    15,000

Net Initial cost of investment                   = P 445,000

Note 1 ) Assumed cost of asset paid in 30days

                Available discount is 500000 x 5% =25000

Sale value of Asset after tax = 105000-30% =105000

Workings :

If old Asset continuous upgraded cost is P 50,000

Therefore total book value becomes 300,000+50000 =P350,000 remaining life 5 Years

Depreciation on New Asset per year         = 535000/5 = P 107,000

Depreciation on Upgraded Asset per year = 350000/5 = P   70,000

Increased depreciation per year          = P    37000

New machine v/s Upgraded old

b)

Cost savings                                            = P 150,000

Increased cost = P 37,000

Gross savings                                          = P 187,000

Less : Tax @30%                                    = (P 56,100)

Increase in Net Annual Income =  P 130,900

Note: if you want total increase in annual income for 5 years @PVAF at 5%= 130900*4.327=P 566,404

c)Increase in Annual Net cashflows

Increase in Net annual income computed above = P 130,900

Add: Increase in Depreciation                                    = P 37,000

Increase in Net Annual Cash flows                        = P 167,900

Note: If you want total increase in 5 years annual cash flows at PVAF at 5% = 167900*4.327 = P 726,503.5