Question

A capital budgeting decision is being considered that would involve an expansion and simultaneous replacement of old equipment. The project is expected to have a 6 year life for the firm.

This project will replace some existing equipment which currently has a book value (BV) of $200k and an estimated market salvage value of $375k. The new project will require new equipment costing $2000k, which will be depreciated straight-line to a book value of $200k at the end of 6 years. Due to new energy efficient technology, replacing the old equipment with the new more efficient equipment will generate an immediate tax credit of 5% of the equipment's cost. The expansion will require an additional investment in NWC of $200k.

Sales are expected to increase by $1000k the first year and grow by 15% in years 2 and 3, then by 5% annually during the remaining 6 year life. Cost of goods sold is forecasted to be 45% of the increased sales, and other selling and general administrative expenses are forecasted to be 10% of the increased sales.

It is forecasted that the new equipment will have a salvage value of $300k at the end of the project's 6 year life.  

The firm's weighted average cost of capital (WACC) for projects of this risk level is 8%. The firm's marginal tax rate is T = 40%.

Questions: Calculate the following

• ATSV old @ t=0
• Equipment
• Tax Credit
• Depreciation per year
• Sales period 1
• CoGS %of sales
• SG&A exp. %of sales
• ATSV new @ t=6

Answer 1

Solution:

After Tax Salvage Value (ATSV) formula if there is a difference between salvage and depreciation value is

= Salvage Value - (Salvage value-Book Value) x Tax rate

ATSV at t=0 for old equipment is - $375,000 - ($375,000-$200,00) x 40% = $375,000 - $70,000 = $ 305,000

Equipment Cost:

New Equipment cost = $2,000,000

Immediate tax credit on new equipment cost = 5% = $100,000

Net equipment cost of selling old equipment and buying new one

= New equipment cost - (tax credit + after tax salvage value of old equipment)

=$2,000,000 - ($100,000 + $305,000)

=$1,595,000

Sales:

Sales will increased by $1,000,000 in first year and increased 15% for next 2 years and there after at 5%

COGS = 45% of increased sales

SG&A = 10% of increased sales

Parameters	1	2	3	4	5	6
Incremental sales	$1,000,000.00	$1,150,000.00	$1,322,500.00	$1,388,625.00	$1,458,056.25	$1,530,959.06
Cost of Goods Sold (COGS)	$450,000.00	$517,500.00	$595,125.00	$624,881.25	$656,125.31	$688,931.58
SG&A	$100,000.00	$115,000.00	$132,250.00	$138,862.50	$145,805.63	$153,095.91

Depreciation per year:

Initial cost of new equipment = $2,000,000

Salvage value of new equipment = $300,000

Straight-line depreciation value per year = (Initial value - Salvage value) / number of years

= ($2,000,000 - $300,000) / 6

= $283,333 per year depreciation value

ATSV at t=6

ATSV at 6 for new equipment = Salvage value - (Salvage value-Book Value) x Tax rate

= $300,000 - ($300,000 - $200,000) x 40%

= $260,000

Project Cash flow structure:

Lets assume that Net Working Capital cost spread across 6 years equally

= $200,000 / 6 = $33,333

Following is the net cash flow table where we subtracted Incremental sales value by all the cost incurred.

We have used WACC as interest expense for new equipment purchase and NWC cost.

COGS, Depreciation and SG&A cost values are not included for WACC interest calculation

Due to higher Depreciation value for new equipment the net free cash flow of project is lower. As depreciation is a non-cash value this project with given values will provide positive higher value.

Parameters	Zero	1	2	3	4	5	6
Incremental sales		1,000,000.00	1,150,000.00	1,322,500.00	1,388,625.00	1,458,056.25	1,530,959.06
Initial Capital Cost
Net equipment cost	1,595,000.00
Net Working Capital cost		33,333.00	33,333.00	33,333.00	33,333.00	33,333.00	33,333.00
Interest cost @ 8% WACC		130,266.64	2,666.64	2,666.64	2,666.64	2,666.64	2,666.64
Cost of Goods Sold (COGS)		450,000.00	517,500.00	595,125.00	624,881.25	656,125.31	688,931.58
New equipment depreciation value		283,333.00	283,333.00	283,333.00	283,333.00	283,333.00	283,333.00
SG&A		100,000.00	115,000.00	132,250.00	138,862.50	145,805.63	153,095.91
Total cost of project		2,591,932.64	951,832.64	1,046,707.64	1,083,076.39	1,121,263.58	1,161,360.12
After Tax Salvage Value (ATSV) at t=6							$260,000
Net Cash Flow		(1,591,932.64)	(1,393,765.28)	(1,117,972.92)	(812,424.31)	(475,631.64)	153,967.30