Company A is trying to determine whether to replace an existing asset. The propo

Question

Company A is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using the simplified straight-line method. The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life. The existing asset was originally purchased three years ago for $25,000, has a remaining life of 5 years, and is being the asset depreciated using the simplified straight-line method. The expected salvage value at the end of the asset's life is $5,000; however, the current sale price of the existing asset is $20,000, and it's current book value is $15,625. Company A is in the 34% marginal tax bracket and has a required rate of return of 12%. Please show your calculations.

a. What is the initial cost of the project?

b. What are the free cash flows generated by this project each other?

c. What is the terminal cash advance?

d. Calculate the value of this project. Should you replace the existing asset?

Explanation / Answer

In this problem, company wants to peplace an existing asset. This old asset was purchased 3 years back at $25,000. It can be used for another 5 years. Current book value of the asset is $15,625. But it can be sold now at $20,000. Its salvage value after 5 year will be $5,000.

New asset can be purchased today at $50,000. It has to be istalled at $3,000. Also it will require additional working capital of $1,500. Its life is also 5 years. Scrap value is $6,000. This new asset will increase sale by $17,000 and operational cost by $2,000. Tax rate is 34% and required rate of return from project is 12%.

Detailed calculations are shown below:

1. In this problem, decision will be taken on the basis of incremental cash flows. It is extra cash flows (inflows and outflows) from such replacement.

2. Initial cost of the project: New machine has purchase price of $50,000. Add installation cost of $3,000 with it. Then deduct sale value of old machine $20,000. It is sold since new machine has replaced it. So no service is required from it. Thus initial incremental cost of the project is $50,000+$3,000-$20,000=$33,000.

3. Additional working capital: It is also incremental cash outflow of period 0. It is assumed that amount is returned in full after 5 years. So it is cash inflow in 5th year.

4. Free cash generated by this project is after tax incremental cash inflows for 5 years. It has been shown in row 13.of the table below.

5. Terminal cash advance will meanthe incremental salvage value received at year 5. It is the excess of salvage value $6,000 over the salvage value of old asset $5,000. The difference is $1,000

6. Depreciation of old asset is (current book value-salvage value)/5 years life. So the amount is ($15,625-$5,000)/5 = $2,125 . For new asset it is ($53,000-$6,000)/5 years=$9,400. So icremental depreciatio is $9,400-$2,125=$7,275.

Result:

a. Initial cost of the project is $33,000 plus recoverable working capital of $1,500

b. Free cash flows of year 1 to year 5 is $12,823.50

c. Terminal cash advance is incremental salvage of $1,000.

d. Value of the project is terminal present worth of $13,144.41. As the incremental present worth is positive, the replacement should be made.

Statement showing incremental cash flow of the replacement project along with its present worth Incremental cash flows: Time 0 1 2 3 4 5 Details Old asset New asset Differece 1 Current market price $ 20,000.00 $ 50,000.00 $ (30,000.00) 2 Installation cost $    3,000.00 $    (3,000.00) 3 Additional working capital $    1,500.00 $    (1,500.00) 4 Total incremental cash flow at time 0 $ (34,500.00) 5 Incremental sale     $ 17,000.00 $ 17,000.00 $ 17,000.00 $ 17,000.00 $ 17,000.00 6 Incremental operating cost     $ (2,000.00) $ (2,000.00) $ (2,000.00) $ (2,000.00) $   (2,000.00) 7 Incremental net sale [5-6]     $ 15,000.00 $ 15,000.00 $ 15,000.00 $ 15,000.00 $ 15,000.00 8 Incremental Depreciation $   2,125.00 $    9,400.00 $   7,275.00 $   7,275.00 $   7,275.00 $   7,275.00 $    7,275.00 9 Net operating profit before tax [7-8] $   7,725.00 $   7,725.00 $   7,725.00 $   7,725.00 $    7,725.00 10 Tax at 34% [9x34%] $   2,626.50 $   2,626.50 $   2,626.50 $   2,626.50 $    2,626.50 11 Net operating profit after tax [9-10] $   5,098.50 $   5,098.50 $   5,098.50 $   5,098.50 $    5,098.50 12 Depreciation add back $   7,725.00 $   7,725.00 $   7,725.00 $   7,725.00 $    7,725.00 13 Cash flow after tax [11+12] $ 12,823.50 $ 12,823.50 $ 12,823.50 $ 12,823.50 $ 12,823.50 14 Incremental salvage value $   5,000.00 $    6,000.00 $      1,000.00 $    1,000.00 15 Return of incremental working capital $    1,500.00 16 Total yearly incremental cash flow [13+14] $ 12,823.50 $ 12,823.50 $ 12,823.50 $ 12,823.50 $ 15,323.50 17 Discount factor of one dollar at 12% $             1.00 $          0.89 $          0.80 $          0.71 $          0.64 $           0.57 18 Present value of cash inflows [16x17] $ 11,449.55 $ 10,222.82 $   9,127.51 $   8,149.57 $    8,694.97 19 Gross incremental present worth $ 47,644.41 20 Incremental outflow of time $ (34,500.00) 21 Incremental present worth $ 13,144.41

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