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 flow?

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

Explanation / Answer

Year 1 2 3 4 5 Increase in Sales a $17,000.00 $17,000.00 $17,000.00 $17,000.00 $17,000.00 Increase in Cost b $2,000.00 $2,000.00 $2,000.00 $2,000.00 $2,000.00 Depreciation per year $53000 / 5 years c $10,600.00 $10,600.00 $10,600.00 $10,600.00 $10,600.00 Earnings before Tax d = a-b-c $4,400.00 $4,400.00 $4,400.00 $4,400.00 $4,400.00 Taxes at 34% e = d*34% $1,496.00 $1,496.00 $1,496.00 $1,496.00 $1,496.00 Earnings after Tax f = d - e $2,904.00 $2,904.00 $2,904.00 $2,904.00 $2,904.00 Depreciation g $10,600.00 $10,600.00 $10,600.00 $10,600.00 $10,600.00 Cashflow from operations h = f+g $13,504.00 $13,504.00 $13,504.00 $13,504.00 $13,504.00 Working Capital Realization i $0.00 $0.00 $0.00 $0.00 $1,500.00 Post tax salvage value of Machine j $0.00 $0.00 $0.00 $0.00 $3,960.00 Net Cashflows k = h+i+j $13,504.00 $13,504.00 $13,504.00 $13,504.00 $18,964.00 PV Factor at 12% l 0.8929 0.7972 0.7118 0.6355 0.5674 Present Value at 12% m = k*l $12,057.14 $10,765.31 $9,611.88 $8,582.04 $10,760.68 PV of Inflow at 12% $51,777.05 Initial Outflow Machine Cost (a) $53,000.00 Post Tax Salvage Value of Old Machine (b) $18,512.50 Note 2 Net Outflow $34,487.50 NPV = $51777.05 - $34487.50 = $17,289.55 Note 1 Purchase Cost of Machine $53,000.00 Less: Accumulated Depreciation $53,000.00 Book Value (a) $0.00 Market Value of Machine (b) $6,000.00 Profit on Sale on Machine (c = b-a) $6,000.00 Tax on Profit (d = c*34%) $2,040.00 Post Tax Salvage Value (b-d) $3,960.00 Note 2 Book Value (a) $15,625.00 Market Value of Machine (b) $20,000.00 Profit on Sale on Machine (c = b-a) $4,375.00 Tax on Profit (d = c*34%) $1,487.50 Post Tax Salvage Value (b-d) $18,512.50 a. Initial Cost of Project = $34,487.50 b. Free Cashflow = $13,504 c. Terminal Year Cashflow = $18,964 d. Project Value = $17,289.55 Yes, Machine should be replaced as it has positive NPV

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