Question

The webtronics has approved a project 5 years ago and the project has 20 years of remaining life. If the old equipment is rpelaced with the new equipment, the operating expenses will decrease by $5 million, since the new equipment is energy-efficent. The old equipment was purchased 5 years ago at a cost of $34 million and assumed to have no value at the end of its 25-year life. The old equipment can be sold for 12 million today. The new equipment is $50 million and was assumed to have no value at the end of the project. The firm uses straight-line depreciation. The marginal tax rate is 20%. If the firm replaces the old equipment now, free cash flows for the next year will

A.) Increase by 4.23 million B.) Increase by 4.02 Million C.) Decrease by 4.57 Million D.) Increase by 4.65 Million E.) Decrease by 3.98 Million

Answer 1

Before replacement

Annual Depreciation = $34,000,000 / 25

= $1,360,000

Annual Depreciation after replacement = $50,000,000 / 20

= $2,500,000

Increase in Annual Depreciation because of replacement = $2,500,000 - $1,360,000

= $1,140,000

Increase in Annual Depreciation because of replacement is $1,140,000.

Cost reduction = $5,000,000

Increase in Before tax income = $5,000,000 - $1,140,000

= $3,860,000

After tax increase in income = $3,860,000 × (1 - 20%)

= $3,088,000.

After tax increase in income is $3,088,000.

So increase in free cash flow = $3,088,000 + $1,140,000

= $4,228,000.

So increase in free cash flow is $4,228,000 or approx $4.23 million.

Option (A) is correct answer.