B Company is considering replacing an existing processor with a new one that cos
ID: 2774265 • Letter: B
Question
B Company is considering replacing an existing processor with a new one that costs $220,000. Shipping and setup costs for the new processor are estimated.to be $13,000. B Company's working capital is expected to increase by $17,000 when the new processor begins operation and is expected to be fully recoverable at the end of the project. The new processor's useful life is expected to be 5 years and its salvage value at that point is estimated to be $49,100. The old processor had an installed cost of $150,000 when it was placed in service three years ago and is being depreciated to a zero book value using a 5 year ACRS life. The processor can be sold today for $26,300. The increase in revenues and before tax cash operating expenses for the new processor compared to continuing with the old processor are shown in the table below. B Company has a marginal tax rate of 34% and a cost of capital of 11%.
Year
Incremental Revenues
Incremental Cash Operating Expenses
ACRS Depr. %
1
$82,000
$25,000
15
2
$77,000
$23,000
22
3
$88,000
$29,000
21
4
$89,000
$23,000
21
5
$88,000
$26,000
21
Fill in the Blanks:
The initial investment for the project is $__________.
The initial investment for the project is $__________.
Incremental depreciation expense for year 2 in the life of the new processor is $__________.
Incremental depreciation expense for year 2 in the life of the new processor is $__________.
After tax salvage value of the new processor at the end of year 5 is $__________.
Operating cash flow after tax (OCFAT) for year 5 of the life of the new processor is $__________.
NPV of the project is $__________.
Year
Incremental Revenues
Incremental Cash Operating Expenses
ACRS Depr. %
1
$82,000
$25,000
15
2
$77,000
$23,000
22
3
$88,000
$29,000
21
4
$89,000
$23,000
21
5
$88,000
$26,000
21
Explanation / Answer
Cost of new processor = $220,000
Set up Cost = $13,000
Increase in Working Capital = $17,000
Proceeds from selling of old machine = $26,300
BV of old machine = 150,000 - (15 + 22 + 21) * 150,000 = $63,000
Loss on sale of old machine = 26300 - 63000 = -36700
Tax shield on this loss = 36700 * 0.34 = $12478
The initial investment for the product = 220,000 + 13,000 +17,000 - 26,300 -12,478 = $211,222
Depreciation in year 2 on new machine = 22% * 233,000 = $51260
Depreciation on old machine had it still been there = 21% * 150,000 = $31,500
Incremental Depreciation for year 2 in the life of the new processor = 51260 - 31500 = $19,760
Book Value of the new processor at the end of 5 year = $0 since it will be fully depreciated.
Salvage Value at that point = $49,100
Tax on sale of the processor = 0.34 * (49100 -0) = $16,694
After Tax Salvage Value of the new processor at the end if year 5 = 49100 - 16694 = $32406
Incremental Revenues in year 5 = $88,000
Incremental Cash Operating Expenses = $26,000
Depreciation Expense = 0.21 * 233,000 = $48930
Tax Shield on Depreciation = 0.34 * 48930 = $16636
Recovery of working capital = $17,000
Operating cash flow after tax (OCFAT) for year 5 of the life of the new processor
= (88000 -26000) * (1 -0.34) + 16636 + 17,000 = $74556
Cash Flows, Discounted Cash Flows and NPV:
Therefore, NPV of the project is the sum of the discounted cash flows = $1,872
Year Incremental Revenue Incremental Expenses New Depreciation Old Depreciation Incremental Depreciation PBT PAT PAT + Depreciation Working Capital Recovery After Tax Salvage Value 1 82000 25000 34950 31500 3450 53550 35343 38793 2 77000 23000 51260 31500 19760 34240 22598 42358 3 88000 29000 48930 0 48930 10070 6646 55576 4 89000 23000 48930 0 48930 17070 11266 60196 5 88000 26000 48930 0 48930 13070 8626 57556 17000 32406Related Questions
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