Alliance is considering automating their production process to become more effic

Question

Alliance is considering automating their production process to become more efficient. In order to do so they will buy a new monorail manufacturing system at a cost of $500,000. The system will be depreciated using seven-year MACRS (15%, 25%, 17%, 12%, 9%, 9%, 9%, 4%). The system will be sold in five years for $200,000. If they buy the system they will Trade In their current trolleys for $100,000. The trolleys were originally bought four years ago for $500,000 and are being depreciated using straight-line depreciation over five years. If Alliance does not replace the trolleys, they will be kept for the next five years when they will be sold for $10,000. The new system will not affect Alliance’s sales but will reduce Costs of Goods Sold by $1,000,000. However, Fixed Costs will rise by $50,000 per year if the monorail system is installed. The tax rate is 40% and the WACC is 10%. What are the incremental cash flows associated with this proposed project?

Balance Sheet Effects              |----------Depreciation Expenses-------------|

Today Year 1   Year 2    Year 3    Year 4      Year 5 End

1. Buy New Assets -500000    100000   100000   100000 100000   100000

2. Trade In Old Assets

3. Keep Old Assets

4. Change in NWC

Income Statement Effects      

              Year 1   Year 2    Year 3        Year 4             Year 5

Net Sales                    

- Net COGS               

- Net Depreciation     

- Net Fixed Costs       

= Net OEBT              

- Net Taxes

= Net OEAT              

+ Net Depreciation

= Net Operating CF   

Total Cash Flows

CF0 = -500000

C01 =

C02 =

C03 =

C04 =

C05 =

C06 =

Explanation / Answer

If replace the New asset new monorail manufacturing system Intitial cass flows Cost of new asset ($500,000) Sale value of old asset $100,000 Net cash flows ($400,000) In between cash flows Year 1 2 3 4 5 Savings in cost of goods sold $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 Fixed cost $50,000 $50,000 $50,000 $50,000 $50,000 Depreciation $75,000 $106,250 $54,188 $31,748 $20,953 Cash flows before tax $875,000 $843,750 $895,813 $918,253 $929,047 Tax@40% $350,000 $337,500 $358,325 $367,301 $371,619 CFAT $525,000 $506,250 $537,488 $550,952 $557,428 Dep $75,000 $106,250 $54,188 $31,748 $20,953 CFAT $600,000 $612,500 $591,675 $582,699 $578,381 Terminal cash flows Written down value of the new asset $211,862 Sale of asset $200,000 Profit on sale of asset $11,862 Tax on profit $4,745 Net cash flows $195,255 Working Note: Year Dep. Rate Opening value Depreciation WDV $500,000 1 15% $75,000 $425,000 2 25% $106,250 $318,750 3 17% $54,188 $264,563 4 12% $31,748 $232,815 5 9% $20,953 $211,862 6 9% $19,068 $192,794 7 9% $17,351 $175,443 Summary Cash flows when brought new asset Year 0 1 2 3 4 5 Cash flows $                    (400,000) $                      600,000 $                      612,500 $                      591,675 $                      582,699 $     773,637 If Alliance does not replace the trolleys trolleys Year Cost Dep WDV 1 $500,000 $50,000 $450,000 2 $50,000 $400,000 3 $50,000 $350,000 4 $50,000 $300,000 5 $50,000 $250,000 6 $50,000 $200,000 7 $50,000 $150,000 8 $50,000 $100,000 9 $50,000 $50,000 10 $50,000 $0

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