Question

7. Premium Pie Company needs to purchase a new baking oven to replace an older oven that requires too much energy to run.  The industrial size oven will cost $1,200,000.  The oven will be fully depreciated on a straight-line basis over its six-year useful life.  The old oven cost the company $800,000 just four years ago.  The old oven is being depreciated on a straight-line basis over its expected ten-year useful life.  (That is, the old oven is expected to last six more years if it is not replaced now.)  Due to changes in fuel costs, the old oven may only be sold today for $100,000.  The new oven will allow the company to expand, increasing sales by $300,000 per year.  Expenses will also decrease by $50,000 per year due to the more energy efficient design of the new oven.  Premium Pie Company is in the 40% marginal tax bracket and has a required rate of return of 10%. What is the net initial outlay for the proposed project?
   What is the annual (operating) cash flow for years 1-4?
8. What is the total cash flow at the end of year five (operating cash flow for year 5 plus terminal cash flow)?

Answer 1

Depreciation of Old oven = (800000-0)/10 = 80000

Depreciation of new oven = (1200000-0)/6 = 200000

Additional Depreciation = 200000-80000 = 120000

Net Initial Outlay = Cost of New Oven - Salvage Value of Old = 1200000-100000 = $1100000

	Year 1 to 4
Increase in Sales	300000
Add: Decrease in Expenses	50000
Less: Additional Depreciation	120000
Profit Before Tax	230000
Less: Tax @40%	92000
Profit After Tax	138000
Add: Depreciation	120000
Operating Cash Flow	258000

Total Cash Flow at Year 5 = Year 5 Cash Flow + PV of Year 6 Cash Flow at Year 5 = Annual Cash Flow same as year 1 to 4 + [Annual Cash Flow same as year 1 to 4/(1+Required Rate of Return)] = 258000 + [258000/(1.1)] = 258000 + 234545.45 = $492545.45