Question

rudy's boat rentals is considering replacing its 5 year old Lowe fishing boats with top of the line Boston Whalers. The Lowe boats have five years of remaining life and will being depreciated at $2,000 per year over the next five years. If they are not replaced, and would have zero salvage value at that time. The boats can currently be sold for $12,000 each. The new Boston Whalers would each cost $25,000 and because of expected increase rentals would have an expected life of only five years and no additional working capital would be required. The boats would be depereciated straight-line to a zero salvage value. They could actually be sold for $10,000 in five years, The new boats are expected to increase revenue by $4,000 per year and have an associated increase in expenses of $1,000 per year. Rudy's required rate of return is 11% and his marginal tax rate is 40%. Conduct your analysis on the replacement of one boat.

What is your inital cash flow? a. -13,800 b. -25,000 c. -13,000 d. -10,000

What is your year one after tax cash flow? a. $5,000 b. $10,000 c. $2,200 d. $3,800

What is the terminal cash flow (not including the year 5 operating cash flow) a. $10,000 b. $6,000 c. $-4,000 d. $22,000

Answer 1

Initial cash flow

Book value of old boat = remaining depreciation = $2000 x 5 = $10,000

Salvage value of old boat net of tax = $12,000 - [ ($12,000 - $10,000) x 40% ] = $11,200

Initial cash flow = (-)Cost of new boat + Salvage value of old boat = (-)$25,000 + $11,200 = (-)$13,800

Year one after tax cash flow

Increase in Revenue	$4000
Less: Increase in expenses	$1000
Less: Depreciation [ $25000 / 5 ]	$5000
Earnings before tax	(-)$2000
Less: Tax@40%	(-)$800
Net Income	(-)$1200
Add: Depreciation	$5000
Cash Flow	$3800

Terminal cash flow

Terminal cash flow is the sale value net of tax of the new boat.

Terminal cash flow = Sale value x (1 - tax rate) = $10,000 x (1 - 0.40) = $6000