Macon Company is considering a new assembly line to replace the existing assembl

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?

(D) Should you replace the existing assembly line? Provide all the details.

Explanation / Answer

1. Initial Cash Outlay = -120,000 - 8,000 - 5,000 - 7,000 = -140,000

Working Capital = Change in Current Assets - Current Liabilities = 12,000 - 5,000 = 7,000. We need to put in 7,000 as working capital for the project, hence negative sign.

2. Operating Cash Flow = Net Profit + Depreciation = -23,000 + 30,000 = 7,000

3. Terminal Cash Flow = Working Capital + Salvage Value (after taxes) = 7,000 + 15,000*(1 - 0.34) = 16,900

4. NPV = NPV(10%, 7000...23900) - 140000 = -106,268

As the NPV is negative, we should not replace the existing assembly line as the new project does not add any value to the company.

0 1 2 3 4 New Assembly -$120,000 Installation -$8,000 Training -$5,000 Working Capital -$7,000 $7,000 Salvage Value $15,000 Revenues $10,000 $10,000 $10,000 $10,000 Cost Savings $5,000 $5,000 $5,000 $5,000 Depreciation -$30,000 -$30,000 -$30,000 -$30,000 Interest Expense -$8,000 -$8,000 -$8,000 -$8,000 PBT -$23,000 -$23,000 -$23,000 -$23,000 Taxes (34%) Net Profits -$23,000 -$23,000 -$23,000 -$23,000 Free Cash Flows -$140,000 $7,000 $7,000 $7,000 $23,900 NPV -$106,268

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