Your company is considering the replacement of an old machine with a new one tha

Question

Your company is considering the replacement of an old machine with a new one that is more efficient. The old machine cost $50,000 when it was purchased 9 years ago. The old machine is being depreciated using the simplified straight line method over a useful life of 10 years. The old machine could be sold today for $4,000. The new machine has an invoice price of $75,000, and it will cost $5,000 for shipping and $20,000 to modify and install the machine. Cost savings from use of the new machine are expected to be $25,000 per year for 5 years, at which time the machine will be worn out and sold for its estimated scrap value of $5,000.The new machine will be depreciated using the simplified straight line method over its 5 year useful life, resulting in depreciation expense of $20,000 per year. The companys tax rate is 35%.Working capital is expected to increase by $10,000 at the inception of the project, but this amount will be recaptured at the end of year 5.What is the incremental free cash flow for year 1?

Explanation / Answer

We have no revenue in this problem so we simply put 0. Cost savings are 25,000 so we put it under operating expense as -25,000. Since operating expenses are already negative, the -25,000 becomes positive because two negatives are a positive. We must subtract depreciation which is 20,000 for the new machine and 5,000 for the old machine. 50,000 divided by 10 years = 5,000. We subtract the 5,000 from 20,000 and have 15,000 depreciation. So, 25,000 operating expense - 15,000 depreciation = 10,000. Minus 35% tax = 10,000x.35 = 3,500 which leaves us with 10,000 - 3,500 = 6,500. Now, we add back the depreciation of 15,000. So, 6,500 + 15,000 = 21,500 incremental cash flow for year 1.

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