Question

The ABD company is considering the purchase of a new machine to replace an out of date machine that has a book value of $18000 and can be sold today for $2,000. The old machine is being depreciated on a straightline basis over 4 more years to a book value of $2000 at the end of the fourth year. The old machine generates annual revenues of $105000 and annual expenses of $75000. This machine requires a fixed investment of $5000 in net working capital. The proposed new machine has an installed and depreciable cost of $125,000 and will be depreciated by 3-yr. ACRS class rules using these percentages: .3334, .4444, .1481, .0741 over the Four years that the machine will be used. The new machine will require a fixed investment of $10500 in net working capital. It is expected to generate annual revenue of $180,000 and annual cash expenses of $90000. If the old machine is used for four more years, it is expected to have only a cash market value of $1500 at the end of the fourth year. The new machine expected to have a cash market value of $42,500. Working capital investments for both machines consists primarily of tools and spare parts that can be sold for full value at any time the machines are retired. The marginal tax rate is 40%. The appropriate discount rate is 12.5%. ANSWER THESE QUESTIONS: 1. What is the "Buy the New" value? 2. What is "Sell the old- net of tax?" 3. What is the Initial Outlay? 4. What is the change in revenue for year 2? 5 What is the change in expenses for year 2? 6. What is the Change in Depreciation for year 2? 7 What is the Change in Taxes for year 2? 8. What is the Operating Cash flow for Year 4? 9, What are the Terminal Cash flows for year 4? 10. Is this an acceptable project (and why - what values support you answer?)

Answer 1

1. What is the "Buy the New" value?

= purchase cost of new asset = $ 125000

2.  What is "Sell the old- net of tax?" $ 8400

Sale value of old asset = $ 2000

Book value of asset on this date = $ 18000

Taxable loss from sale = 2000 - 18000 = $ 16000

So,the tax benefit from the loss @ rate of 40% * 16000 = 6400 as infflow

Total cash from sale of old asset =2000 + 6400 =$ 8400

3.  What is the Initial Outlay? $ 122100

new machine has an installed cost = $ 125000 ooutflow

increase in net working capital = 10500 - 5000 = $ 5500 outflow

cash from sale of old asset =$ 8400 inflow

Total initial outlay = (125000 + 5500) - 8400 = $ 122100

4.  What is the change in revenue for year 2 ? $ 75000

Increase in revenue = new revenue - old revenue =

= $ 180000 - $ 105000 = $ 75000 each year is same

5 What is the change in expenses for year 2 ? $ 15000

Increase in Expenses = new expenses - old

= $ 90000 - $ 75000 = $ 15000

6. What is the Change in Depreciation for year 2? $ 51550

each year depreciation of old asset is same, because it use stright line method

old assets depreciation

depreciable base = 18000 - 2000(book value at the end of 4th year) = 16000 / no. of years = 4

dep. exp = 16000 / 4 = 4000 each year is same so 2nd year is also same

Table 1 New asset depreciation at ACRS methode

year and ACRS %	1= 0.3334	2 = 0.4444	3 = 0.1481	4 = 0.0741
new asst cost = 125000	125000*0.3334 =41675	= 55550	18512.5	= 9262.5
old one	4000	4000	4000	4000
incremental	=37675	=51550	=14512.5	=5262.5
Dep tax sheild at rate 40% = incremental * tax rate	37675*40% =15070	=20620	=5805	=2105

2 nd year dep exp = 55550

change in depreciationn = New mechine deep. - old mechine dep.

= 55550 - 4000 = $ 51550

7. What is the Change in Taxes for year 2? $ 3380

Incremental revenue = $ 75000

- Incremental expenses = $ 15000

= Net incremental earning before tax and dep = 75000 - 15000 = 60000

- depreciation = 51550

= Net incremental earning before tax = 8450

increase in Tax on Net incremental earnings = 8450*40% = 3380

8. What is the Operating Cash flow for Year 4? $38105

Incremental revenue = $ 75000

- Incremental expenses = $ 15000

= Net incremental earning before tax and dep = 75000 - 15000 = 60000

- tax increased = 60000 * 40% = 24000

= Earning after tax cash flow (excluding dep.) = 36000

- depreciation tax sheild (calculation on above table 1) = 2105

= Net incremental operating cash flow = 38105

9, What are the Terminal Cash flows for year 4? $ 29300

sale of new mechine (market value ) = 42500

Book value (fully depreciated) = 0

taxable gain = 42500

tax on gain @ rate of 40% 42500 * 40% = 17000 as outflow

net cash received from sale of new mechine = 42500 - 17000 = $ 25500 cash inlow

opportunity cost old asset salvage

book value of old asset = 2000

market value of old mechine = 1500

taxable loss = 500

tax benefit from loss = 500 * 40% = 200

net opportunity cost avoided from old asset = 1500 + 200 = 1700 cosider as outflow

release of working capital = 5500 cash inflow

Total terminal cash flow = 25500 + 5500 - 1700 = 29300

10. Is this an acceptable project (and why - what values support you answer?)

I took NPV for support this project acceptabilty or not

Table 2 calculation of NPV

Year	0(initial)	1	2	3	4
initiaal outlay(calculation on problem 3)	$ 122100
operating cash flow (excludig dep.) same as each year (calculation is below) $ 36000(75000 - 15000) - 40%		36000	36000	36000	36000
Dep. tax sheild (calculation on table 1 above)		15070	20620	5805	2105
Terminal cash flow (inflow- calculation on problem number 9 on above)					29300
Net cash flow	(122100)	51070	56620	41805	67405
*PV factor for $1 at discount rate of 12.5%	1	(1/1.125)1 =0.889	(1/1.125)2 = 0.79	(1/1.125)3 = 0.702	(1/1.125)4 = 0.624
PV of Net cash flow	(122100)	45401	44730	29347	42061

NPV = PV of cash inflow - PV of cash outflow

NPV = 161539 - 122100 = $ 39439

Here the NPV is positive, so we can accept the project. if we accept a project with positive NPV, it will add value to the business and increas the wealth of shareholders.

operating cash flow each year (excluding deoreciation) same as each year

Incremental revenue from old to new = 180000 - 105000 = 75000

incremental exp. = 90000 - 75000 = 15000

incremental eaarning = 60000

tax @ 40% = 24000

operating cash flow (excludig dep.) = 36000