Question

​(Replacement project cash​ flows)  The Minot Kit Aircraft Company of​ Minot, North​ Dakota, uses a plasma cutter to fabricate metal aircraft parts for its plane kits. The company currently is using a cutter that it purchased four years ago that has a book value of ​$70 comma 000 and is being depreciated ​$17 comma 500 per year over the next 4 years. If the old cutter were to be sold​ today, the company estimates that it would bring in an amount equal to the book value of the equipment. The company is considering the purchase of a new automated plasma cutter that would cost ​$360 comma 000 to install and that would be depreciated over the next 4 years toward a ​$36 comma 000 salvage value using​ straight-line depreciation. The primary advantage of the new cutter is the fact that it is fully automated and can be run by one operator rather than the three employees that are currently required. The labor savings would be ​$90 comma 000 per year. The firm faces an income tax rate of 28 percent. At the end of the​ 4-year project both cutters could be sold at their​ end-of-project book value.

a.    What are the differential operating cash flow savings per year during years 1 through 4 for the new plasma​ cutter?

b. What is the initial cash outlay required to replace the existing plasma cutter with the newer​ model?

c. What does the timeline for the replacement project cash flows for years 0 through 4 look​ like?

d. If the company requires a discount rate of 13 percent for new​ investments, should the plasma cutter be​ replaced?

Answer 1

Part a.

The operating cash flow savings per year come from two areas:

1. Labour savings: $90,000 per year, and

2. Tax savings on incremental Depriciation:

Depriciation of old machine is given to be $17,500

For new machine, salvage value given = $36,000. So depriciation using SL method = (initial cost-salvage value)/project life

=($360,000-$36,000)/4

=$81,000

Now we calculate the deprciation tax savings as:

= Tax rate * Incremental depriciation = 28% * (81,000-17,500) = $17,780

So the total differential operating cash flow savings per year will be the sum i.e. $107,780

Part b.

The inital outlay would simply comprise of the cost of new machine (outflow) plus salvage value of old machine (inflow) as:

Initial capital outlay
Cost of new plasmacutter	$ -3,60,000.00
Salvage value of old machine	$       70,000.00
Net initial outlay	$ -2,90,000.00

Part c.

For the timeline, we combine the initial, operating & terminal cash flows as below to find net cash flows:

Year	0	1	2	3	4
Initial capital outlay for replacement
Cost of new plasmacutter	$ -3,60,000.00
current Salvage value of old machine	$       70,000.00
Net initial outlay	$ -2,90,000.00
Differential Operating cash flow
Labour savings		$           90,000	$           90,000	$           90,000	$           90,000
Incremental depriciation		$           63,500	$           63,500	$           63,500	$           63,500
Depriciation tax savings		$           17,780	$           17,780	$           17,780	$           17,780
Net differential operating cash flow		$       1,07,780	$       1,07,780	$       1,07,780	$       1,07,780
Terminal cash flow
Salvage value of new machine					$           36,000
Salvage value of old machine					$                    -
Total Defferential terminal cash flow					$           36,000
Net Differential Cash flow	$       -2,90,000	$       1,07,780	$       1,07,780	$       1,07,780	$       1,43,780

So the timeline for replacement project would look like (starting from year 0 to year 4):

$107,780 $107,780 -$290,000 $107,780 $143,780

Part d.

To determine whether the replacement should be done or not, we calculate the project NPV using the above net cash flow stream & 13% deiscount rate as :

A. Е G Н 26 $-2,90,000.00 $1,07,780.00 $1,07,780.00 $1,07,780.00 $1,43,780.00 Net Differential Cash flow 27 28 29 52,667.99 NPV(13%,E27:H27)+D27 30

(you may calculate NPV manully or using financial calculator if Excel is not available)

Now as the NPV of replacement project comes out to be +ive, we conclude that the plasma cutter should be replaced.