Question

The Genland has approved a project 10 years and the project has 20 years of remaining life. If the old equipment is replaced with the new equipment, the Operating Expenses will decrease by 9 million, since the new equipment is energy-efficient. The old equipment was purchased 10 years ago at a cost of 33 million and was assumed to have no value at the end of its 30-year life. The old equipment can be sold for 16 million today. The new equipment is 40 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 flow for the next year will A.) Increase by 6.79 million B.) Decrease by 7.82 million C.) Increase by 7.38 million D.) Increase by 7.62 million E.) Decrease by 6.94 million

Answer 1

Depreciation per year on Old equipment = $33 million / 30 = $1.1 million

Depreciation per year on the new equipment = $40 million / 20 = $2 million

Tax shield on Incremental Depreciation = (Depreciation on new equipment - Depreciation on old equipment) x Tax rate

or, Tax shield on incremental depreciation = ($2 million - $1.1 million) x 20% = 0.18 million

Incremental savings in operating expenses net of tax = $9 million x (1 - 0.20) = $7.20 million

Increase in FCF next year = Incremental savings in operating expenses + Tax shield on incremental depreciation

or, Increase in FCF next year = $7.20 million + $0.18 million = $7.38 million (Option C)