Question

2. Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the existing grill. This new grill can be purchased for $80,000 and would be depreciated straight line over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill will produce an operating income (which is equal to revenue minus COGS and overhead costs) of $50,000 per year for the next eight years while the existing grill produces an operating income of only $35,000 per year. The current grill is being depreciated straight line over its useful life of 10 years after which it will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty Krab's tax rate is 35%. (1) Calculate the free cash flow in year for the grill replacement proposal (2) Calculate the free cash flow in year 1

Answer 1

1) Cash flow in year 0 = purchase cost of new equipment - sale of old equipment ( 1-tax )

= 80,000 - 30,000 (1 - 0.35)

= 80,000 - 19,500

= 60,500

Cash flow in year 0 is (60,500).

2) Cash flow in year1

Operating profit. 50,000

(-) Depreciation 10,000

EBT.    40,000

(-) Tax 35% 14,000

Profit. 26,000

(+) Depreciation. 10,000

Free cash flow 36,000

Notes:-

Depreciation of new machine = 80,000 / 8 = 10,000 because It is depreciated in straight line.