Question

Questions #1 Storey, Inc. is considering the purchase and installation of new manufacturing equipment to replace its old, worn-out equipment. The following information is available. 1. Useful life of the new equipment, 8 years. 2. Cost of new equipment, $3,600,000. 3. Cost to set up new equipment, $200,000. 4. Estimated selling price of the new equipment at the end of its useful life, $60,000. 5. Annual operating savings, $700,000. 6. Working capital investment required, $600,000. This amount will be released at the end of the project. 7. Upgrade expense to the equipment at the end of the 5th year, $200,000. 8. Cost of the old equipment is $900,000 while the accumulated depreciation is $500,000 and the estimated market value is $300,000. 9. Tax rate is 25%. Cost of capital is 10%. Required: Should Storey invest in the new equipment?

Answer 1

	Year	Savings in cost	Tax outflow on savings @ 25%	Tax inflow in depreciation	Cash flow on assets	Working capital	Net Cash flow	Present value@ 10%	Present value@ 10%
	A	B	C=B*25%	D=Refer Note 1	E=Note:-3	F	G=A+B+C+D+E+F		I=G/(1+10%)^A
	0				(3,500,000)	(600,000)	(4,100,000)	=Net Cash flow/(1+10%)^year	(4,100,000)
	1	700,000	(175,000)	118,750	-		643,750	=Net Cash flow/(1+10%)^year	585,227
	2	700,000	(175,000)	118,750	-		643,750	=Net Cash flow/(1+10%)^year	532,025
	3	700,000	(175,000)	118,750	-		643,750	=Net Cash flow/(1+10%)^year	483,659
	4	700,000	(175,000)	118,750	-		643,750	=Net Cash flow/(1+10%)^year	439,690
	5	700,000	(175,000)	131,250	(200,000)		456,250	=Net Cash flow/(1+10%)^year	283,295
	6	700,000	(175,000)	131,250	-		656,250	=Net Cash flow/(1+10%)^year	370,436
	7	700,000	(175,000)	131,250	-		656,250	=Net Cash flow/(1+10%)^year	336,760
	8	700,000	(175,000)	131,250	85,000	600,000	1,341,250	=Net Cash flow/(1+10%)^year	625,703
								Net Present value	(443,205)
	Conclusion:- the Company should not invest in the asset as the it has negative Net Present value from the asset
		Note:- 1 Computation of depreciation and tax inflow due to tax shield
		Year	Depreciation on original asset	Depreciation on upgrade expenses	Total Depreciation	Tax Shield on depreciation@25%
			=(3,600,000+200,000)/8 years	=(200,000)/4 years
		1	475,000		475,000	118,750
		2	475,000		475,000	118,750
		3	475,000		475,000	118,750
		4	475,000		475,000	118,750
		5	475,000	50,000	525,000	131,250
		6	475,000	50,000	525,000	131,250
		7	475,000	50,000	525,000	131,250
		8	475,000	50,000	525,000	131,250
		Total	3,800,000	200,000	4,000,000	1,000,000
		Note:-2	Tax outflow on sale of asset
			It is assumed that tax rate of 25% on capital gain tax on sale of assets
		Cell Reference	Particulars	Amount $
		A	Original cost of asset	900,000
		B	Accumulated depreciation	500,000
		C=A-B	Written down value of asset	400,000
		D	Estimated market value	300,000
		E=C-D	Loss on sale of asset	100,000
		F=E*25%	Tax inflow due to tax shield on loss of sale of Asset @25%	25,000
		Note:-3	Cash flow on related to asset
		Years	Cash flow on assets	Nature of cash flow
		0	(3,500,000)	Purchase of asset ($3,600,000) along with cost of set up of asset ($200,000) reduced by sale value of old asset ($300,000)
		1
		2
		3
		4
		5	(200,000)	Upgrade expenses
		6
		7
		8	85,000	Estimate selling price of new asset at the end of life of asset ($ 60,000) and tax inflow on loss of sale of asset Refer Note:-2