Question

2. A firm is contemplating the purchase of new automated plant costing $240,000 to replace an existing machine that can be sold for $110,000 today. The existing machine (which can continue to be operated for a further four years) was purchased one year ago for $100,000 and is being depreciated over its five-year life. For each year of its life the new plant's technology will allow the firm to reduce annual expenses by $80,000. Annual sales will remain at the current level of $160,000 with the new machine. Although the new machine will only be used for a four-year period, it has an eight-year depreciable life and an assumed disposal value of zero in four years' time. What are the relevant cash flows for each year of the new machine's life? Assume the company tax rate is 30%.

Answer 1

• 		INITIAL INVESTMENT FOR REPLACEMENT
  	A	Total Cost of new asset	$240,000
  	B	Current market Value of old equipment	$110,000
  	C	Accumulated Depreciation of old equipment	$20,000	(100000/5)
  	D	Current book value of old equipment	$80,000	(100000-20000)
  	E=B-D	Gain on sale of old equipment	$30,000	(110000-80000)
  	F=E*30%	Tax on gain on sale of old equipment	$9,000
  	G=A-(B-F)	Net Cost of New Equipment	$139,000
  		Cash Flow in Year 0	-$139,000
  		OPERATING CASH FLOW
  		Total Cost of New Equipment	$240,000
  		Salvage Value	$0
  		Useful Life in years	8
  		Annual Depreciation of New Equipment	$30,000	(240000/8)
  		Annual Depreciation of old Equipment	$20,000
  		Incremental Depreciation	$10,000
  		Annual Depreciation Tax shield	$3,000	(10000*30%)
  			OPERATING CASH FLOW
  					Tax Rate=30%
  			N	A	B=A*(1-0.3)	C	D=B+C
  			Year	Before tax annual saving	After Tax annual saving	Depreciation Tax shield	Operating Cash Flow
  			1	$80,000	$56,000	$3,000	$59,000
  			2	$80,000	$56,000	$3,000	$59,000
  			3	$80,000	$56,000	$3,000	$59,000
  			4	$80,000	$56,000	$3,000	$59,000
  		Terminal Cash Flow
  		Salvage Value of New Equipment	$0
  		Accumulated Depreciation	$120,000	(30000*4)
  		Book Value of the new equipment	$120,000	(240000-120000)
  		Loss on Disposal of new equipment	$120,000
  		Tax Saving on Loss =120000*30%	$36,000
  		Total Cash Flow in Year 4	$95,000	(59000+36000)
  		Year	Relevant Cash Flow
  		0	-$139,000
  		1	$59,000
  		2	$59,000
  		3	$59,000
  		4	$95,000