Question

Mom's Cookies Inc. is considering the purchasing of a new cookie oven. The original cost of the old oven was $44,000 it os now five years old, and it has a current market value of $19,500. The old oven is being depreciated over a 10-year life towards a zero estimated salvage value on a straight line basis resulting in a current book value of $22,000 and an annual depreciation expense of $4,400.The old oven can be used for six more years but has no market value after its depreciable life is over. Managment is contemplating the purchase of a new oven whose cost is $27,000 and whose estimated salvage value is zero. Expected before tax cash savings from the new oven are $3,500 a year over its life, you can use bonus depreciation on the oven and the cost of capital is 10 percent. Assume a 21 percent tax rate.

What will the cash flows for this project be?

Answer 1

Given 44000 Old oven cost Current market value old oven 19500 Depreciation old oven 4400 current book value old oven 22000 New oven cost 27000 Salvage Value 0 Life New oven years Annual Saving 3500 21% Tax Rate Cost of capital 10% Solution Step 1: Calculate Initial cashflow on purchase of new machine and replacement of old machine, Depreciation new asset Calculation of Book Value (Current Sale Value) at end of 1st year Particulars Amount Cost of new machine 27000 Less: Sale Value of old machine 19500 Less: Tax Saving on sale of old machine 525 Net Cashflow for new machine 6975 Note: Tax Saving (Book Value - Sale Value) X Tax Rate Depreciation new asset Cost-Salvage Depreciation Life 27000 6 4500 Step 2: Change in annual Depreciation allowance Depreciation Depreciation Change in Old Year New Depreciation 4400 4400 4400 1 4500 100 4500 100 100 100 100 4500 4500 4400 4 4400 4500 4500 6 4500 Total 27000 22000 5000 Note: Change in Depreciation Old Depreciation - New Depreciation

Step 3: Cash Flow Annual Additional Net Cash Year CFAD CFADT Saving 3500 Depreciation Flow 2786 2786 2786 2686 1 100 3400 3500 2 100 3400 2686 3500 100 3400 2686 3500 4 100 3400 2686 2786 3500 100 3400 2686 2786 3500 3710 790 6 4500 -1000 where Depreciation (Dep.) Fictional Cash Flow (Used on for Tax Calulation) Cash flow after Depreciation CFAD CFADT (Cash flow after Dep. & Tax) CFAD X (1- Tax Rate) CFADTDepreciation Net Cash Flow