Macon Company is considering a new assembly line to replace the existing assembl
ID: 2744779 • Letter: M
Question
Macon Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 2 years ago at a cost of $90,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 4 more years. The new assembly line costs $120,000; requires $8,000 in installation costs and $5,000 in training fees; it has a 4-year usable life and would be depreciated under the straight-line method. The new assembly line will increase output and thereby raises sales by $10,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $15,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $12,000. At the end of 4 years, the existing assembly line is expected to have a market value of $4,000; the new assembly line would be sold to net $15,000 before taxes. Finally, to install the new assembly line, the firm would have to borrow $80,000 at 10% interest from its local bank, resulting in additional interest payments of $8,000 per year. The firm pays 34% taxes and its shareholders require 10% return.
(A) What is the initial cash outlay for this replacement project?
(B) What is the operating cash flow of the project?
(C) What is the terminal cash flow of th
(D) Should you replace the existing assembly line? Provide all the details.
Explanation / Answer
(A) Initial cash outlay for this replacement project
Initial cash outlay = Total Cost of new assembly line + Additional working capital – Sale value of old assembly line
Total Cost of new assembly line = Cost price + Installation costs + Training fees = $120,000 + $8,000 + $5,000 = $133,000
Additional working capital = Increase in accounts receivable – Increase in accounts payable = $12,000 - $5,000 = $7,000
Sale price of old assembly line = $15,000
So, Initial cost outlay = $133,000 + $7,000 - $15,000 = $125,000
(B) Operating cash flow of the project
Year 1 Year 2 Year 3 Year 4
Increased sales 15,000 15,000 15,000 15,000
Add: Decrease in production expense 5,000 5,000 5,000 5,000
20,000 20,000 20,000 20,000
Tax @34% (6,800) (6,800) (6,800) (6,800)
13,200 13,200 13,200 13,200
Tax-savings on depreciation of new assembly* 10,200 10,200 10,200 10,200
Operating cash flows 23,400 23,400 23,400 23,400
PVF** @ 10% p.a. 0.909 0.826 0.751 0.683
Present value of operating cash flows 21,270 19,328 17,573 15,982
*Depreciation on new assembly line = Cost
Useful life
= $120,000
4
= $30,000
Tax-saving on depreciaiton = $30,000*34% = $10,200
**PVF means Present Value Factor
(C) Terminal cash flow of th???
Sale value of new assembly line (Post-tax) = $15,000 (1-0.34) = $9,900
Tax-saving on loss on sale at the end of 4th year = $15,000*34% = $6,100
PVF @ 10% of 4th year = 0.683
Present value of terminal cash flow = $9,900 + $6,100 = $10,245
(D) Should you replace the existing assembly line
If the net total of (A) to (C) is positive i.e. Inflow, then we should replace the existing assembly line
-125,000 + 21,270 + 19,328 + 17,573 + 15,982 + 10,245 = -40,602
Hence, we should not replace the existing assembly line
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