Question

Cranberry Manufacturing Company is considering an asset replacement project of replacing a control device. This old control device has been fully depreciated but can be sold for $4,000. The new control device, which is more automated, will cost $34,000. The new device’s installation and shipping costs will total $14,000. The new device will be depreciated on a straight-line basis over its 2-year economic life to an estimated salvage value of $0. The actual salvage value of this device at the end of 2-year period (That is, the market value of the device at the end of 2-year period) is estimated to be $5,000. If the replacement project is accepted, Cranberry will require an initial working capital investment of $2,500 (that is, adding $2,500 initially to its net working capital).
During the 1st year of operations, Cranberry expects its annual revenue to increase from $65,500 to $85,000. After the 1st year, revenues from the replacement are expected to increase at a rate of $3,200 a year for the remainder of the project life.

Cranberry's incremental operating costs associated with the replacement project are expected to decrease from $25,000 to $17,000 during the 1st year and increase at a rate of $2500 for the remainder of the project life.

Cranberry expects that it will have to add about $3,000 to its net working capital in year 1, and nothing in year 2. At the end of the project, the total accumulated net working capital required by the project will be recovered.

Cranberry has a marginal tax rate of 30%. What is the initial net investment for Cranberry to undertake this replacement project?

Answer 1

Sale of old device = $4,000

Book Value of old Device = 0

Gain on sale of old device = $4000 – 0 = $4000

Tax on Gain = 30% * 4000 = $1200

Net Cash from Sale of Old Device = $4000 - $1200 = $2800

Cost of New device = $34,000.

Installation and shipping costs = $14,000

Initial working capital = $2,500

Initial net investment for Cranberry = Cost of New Device + Installation & Shipping costs + Initial Working capital – Net Cash from sale of old device

= $34,000 + $14,000 + $2,500 - $2800 = $47,700.00

Initial Net Investment for Cranberry = $47,700