Question

The Everly Equipment Company's flange-lipping machine was purchased 5 years ago for $50,000. It had an expected life of 10 years when it was bought and its remaining depreciation is $5,000 per year for each year of its remaining life. As older flange-lippers are robust and useful machines, this one can be sold for $20,000 at the end of its useful life. A new high-efficiency digital-controlled flange-lipper can be purchased for $120,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by $35,000 per year, although it will not affect sales. At the end of its useful life, the high-efficiency machine is estimated to be worthless. MACRS depreciation will be used, and the machine will be depreciated over its 3-year class life rather than its 5-year economic life, so the applicable depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%. The old machine can be sold today for $40,000. The firm's tax rate is 25%, and the appropriate cost of capital is 14%. a. If the new flange-lipper is purchased, what is the amount of the initial cash flow at Year O? Round your answer to the nearest dollar. Cash outflow, if any, should be indicated by a minus sign. b. What are the incremental net cash flows that will occur at the end of Years 1 through 5? Do not round intermediate calculations. Round your answers to the nearest dollar. Cash outflows, if any, should be indicated by a minus sign. CFS c. What is the NPV of this project? Do not round intermediate calculations. Round your answer to the nearest whole dollar. Negative value, if any, should be indicated by a minus sign. Should Everly replace the flange-lipper? -Select-

Answer 1

Solution:

a) We have in this question three important information in order to determine the initial cash flow at Year 0, they are
1) Flange lipping machine was purchased 5 years ago with a cost of $50,000 and had an expected life of 10 years.

2) The new digital machine purchased at $ 120,000 including installation cost.

3) The old machine , that is, which was purchased 5 years ago can be sold at $40,000 and there is a tax rate of 25%.

Based on the above information, we can determine the Cash flow at year 0 , which is net cash outflow.

Step 1: Using Information 1), we will depreciate the assets based on its useful life for 5 years in order to reach its book value at the end of Year 5, which is now, i.e Year 0 for decision making for new machine purchase.

Book Value of old Machine is , Original cost minus depreciation over its useful life of 10 years at 5th year

Depreciation for 5 years , ($50,000/10)*5 = $25000

Book Value of Machine at 5th year is $50,000- $25,000= $25,000

Step 2: Using Information 3, it can be sold for $40,000 , therefore net gain or cash inflow would be = $40,000-$25,000= $15,000

Using tax rate of 25%, Tax expense would be $15,000*25%= $3,750 (which is cash outflow)

Step 3: Net Cash inflow from sale of old Assets , Cash inflow from sale of old assets from Step 2 - Tax expenses from Step 2, we get: $15,000-$3,750= $11,250

Step 4: Using information 2 , Cash outflow for new machine is $120,000.

Therfore net cash flows are:

Particulars	Amount( $)
Cash outflow for new machine	120,000
Less: Net Cash inflow from old assets ( as per Step 3)	11,250
Net Cash outflow at Year 0	108,750

b) Net Incremental Cash flows = Present Value of Reduced Cash Operating Expenses plus Present value of Tax shield/ saving in Depreciation.

Let us Calculate the Present Value of reduced Cash Operating Expenses

Year	Reduced Cash operating Expenses ($)	Discounting Factor @ 10.5% (Note)	Discounted Value ($)
1	35,000	0.9409	32,931.50
2	35,000	0.8189	28,661.50
3	35,000	0.7411	25,938.50
4	35,000	0.6707	23,474.50
5	35,000	0.6069	21,241.50
		Total	132,247.5

Note: Discounting Factor after tax ( assuming pre tax rate of 14%), 14%(1-0.25)= 10.5%

Now we will calculate Depreciation and its Present Value.

Since MACRS Depreciation is used thereby reducing the years from 5 to 3 year class life.

Depreciation Chart and Present Value on Tax Saving on Depreciation

Years	Rate of Depreciation (1)	Depreciation ($) (2)= (1) *$120,000	Tax Saving @ 25% * (3) ($)	Discounted factor @ 10.5% (4)	Present Value of Depreciation ($) (5) = (3)*(4)
1	33.33%	39,996	9,999	0.9409	9,408.05
2	44.45%	53,340	13,335	0.8189	10,920.03
3	14.81%	17,772	4,443	0.7411	3,292.70
4	7.41%	8,892	2,223	0.6707	1,490.97

Now, net incremental cash flow chart is as follows:

Years	Present Value of reduced Cash Operating Expenses ($) (1)	Present Value on Tax Saving on Depreciation ($) (2)	Net Incremental Cash flows ($) (3)= (1)+(2)	Rounded of Net Incremental Cash Flows ($)
1	32,931.50	9,408.05	42,339.55	42,340
2	28,661.50	10,920.03	39,581.53	39,582
3	25,938.50	3,292.70	29,231.20	29,231
4	23,474.50	1,490.97	24,965.47	24,965
5	21,241.50	21,241.50	-	21,242
	Net Incremental Cash flows			157,360

c) NPV of the project = Net Incremental Cash flows (in $) - Cash outlows at Year 0 (in $)

NPV of the project = $157,360- $108,750 = $48,610

Yes, Everly should replace the machine as the net present value is positive of $ 48,610 , considering all the relevant factors.