Company A is trying to determine whether to replace an existing asset. The propo
ID: 2484681 • Letter: C
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 flow?
d. Calculate the value of this project. Should you replace the existing asset?
Explanation / Answer
a.
Cost of proposed asset = Purchase price of asset +Installation cost = $50,000 + $3,000 = $53,000
Working capital investment = $1,500
Sale value of existing asset = $20,000
Book value of existing asset = $15,625
Gain on sale of existing asset = $20,000 - $15,625 = $4,375
Tax on gain on sale of existing asset = $4,375 * 34% = $1,487.50
Proceeds from sale of existing asset = $20,000 - $1,487.50 = $18,512.50
Net initial cost of project = Cost of proposed asset + Working capital investment – Proceeds from sale of existing asset = $53,000 + $1,500 - $18,512.50 = $35,987.50
b.
Increase in sales = $17,000
Increase in non-depreciation expenses = $2,000
Net operating income = $17,000 - $2,000 = $15,000
Net income after taxes = $15,000 * (1 – 0.34) = $9,900
Annual depreciation on proposed asset = (Cost of proposed asset - Salvage value)/ Useful life of proposed asset = ($53,000 - $6,000)/5 = $9,400
Tax savings on depreciation expense = $9,400 * 0.34 = $3,196
Free cash flows = Net income after taxes + Tax savings on depreciation = $9,900 + $3,196 = $13,096
c.
Sale value of proposed asset at the end of 5 years = $6,000
Book value of proposed asset at the end of 5 years = $53,000 – ($9,400 * 5) = $6,000
Gain on sale of proposed asset = $0
Net proceeds on sale of proposed asset = $6,000
Release of working capital investment at the end of 5 years = $1,500
Terminal cash inflow = $6,000 + $1,500 = $7,500
d.
Year
Cash flows
Present value factor @ 12%
Present value of cash flows
0
-$ 35,987.50
1
-$ 35,987.50
1
$ 13,096.00
0.8929
$ 11,693.42
2
$ 13,096.00
0.7972
$ 10,440.13
3
$ 13,096.00
0.7118
$ 9,321.73
4
$ 13,096.00
0.6355
$ 8,322.51
5
$ 13,096.00
0.5674
$ 7,430.67
5
$ 7,500.00
0.5674
$ 4,255.50
Net present value (NPV)
$ 15,476.46
Hence, value of project = $15,476.46
Existing asset should be replaced because the value of project is positive.
Year
Cash flows
Present value factor @ 12%
Present value of cash flows
0
-$ 35,987.50
1
-$ 35,987.50
1
$ 13,096.00
0.8929
$ 11,693.42
2
$ 13,096.00
0.7972
$ 10,440.13
3
$ 13,096.00
0.7118
$ 9,321.73
4
$ 13,096.00
0.6355
$ 8,322.51
5
$ 13,096.00
0.5674
$ 7,430.67
5
$ 7,500.00
0.5674
$ 4,255.50
Net present value (NPV)
$ 15,476.46
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