Question

# A company is considering replacing an old equipment with a new, more advanced machine. The new...

A company is considering replacing an old equipment with a new, more advanced machine. The new machine costs \$100,000, will be used for 5 years, and with a salvage value of \$10,000. The old machine has a current book value of \$55,000, has 5 years of life remaining, an after-tax salvage value of \$55,000 today and \$5,000 (after-tax) after 5 years, and an annual depreciation of \$10,000. The new machine is expected to increase annual sales by \$30,000, and an annual increase in costs of \$5,000 (excluding depreciation).   Required rate of return is 10 percent, and tax rate is 40 percent.

What is the project's operating cash flow in the 3rd year?

Project's Operating Cash Flows in the 3rd year :

Operating Cash Flow = [(Incremental Sales - Incremental Cost ) * (1 - Tax rate)] + Tax Shield on incremental Depreciation

Depreciation on New Machine = (Cost of Machine - Salvage Value ) / Number of year of useful Life

= (100000 - 10000) / 5

= 90000 / 5

= 18000

Depreciation on Old Machine = 10000

Incremental Depreciation = Depreciation on New Machine - Depreciation on Old Machine

= 18000 - 10000

= 8000

Operating Cash Flow = [(30000 - 5000 ) * (1 - 0.40)] + (8000 * 0.40)

= [ 25000 * 0.60 ] + 3200

= 15000 + 3200

= 18200

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