Question

Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the existing grill. This new grill can be purchased for $80,000 and would be depreciated straight line over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill will produce an operating income of $50,000 per year for the next eight years while the existing grill produces an operating income of only $35,000 per year. The current grill is being depreciated straight line over its useful life of 10 years after which it will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty Krab's tax rate is 35%.

(1) Calculate the free cash flow in year 0 for the grill replacement proposal

(2) Calculate the free cash flow in year 1

Answer 1

Cash Flow
Year	0
Old Grill
Sale value	30000
Book value of Grill	40000
Loss	-10000
Tax shield @ 35%	3500
Post tax sale value	33500
New Grill
Purchase of New Grill	80000
So Net Cash Flow	-46500
Year	1
Old Grill
Operating income	35000.00
Depreciation	5000.00
Tax shield	1750.00
Total cash flow from old grill	36750.00
New Grill
Operating income	50000.00
Depreciation	10000.00
Tax shield	3500.00
Total cash flow from old grill	53500.00
Incremental Cash flow	16750.00