A firm is trying to determine whether to replace an existing asset. The proposed

Question

A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using the straight-line method. The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital during the asset's life of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life. The existing asset was originally purchased three years ago for $25,000, has a remaing life of five years, and is being depreciated using the straight-line method. The expected salvage value at the end of the asset's life (i.e., five years from now) is $5000; however, the current sale price of the existing asset is $20,000, and its current book value if $15625. The firm's marginal tax rate is 34 percent and its required rate of return is 12%. What is the net incremental tax cash flow?

a. 13,504

b. 13,761.50

c. 14,824

d. 12,441.50

Explanation / Answer

To be frank, this is WAY too complicated to try to explain in a forum like this. Especially since you need to take it one step at a time, make sure you understand that step, before moving to the next step, etc. And I'm not going to do any of the steps for you so that I can then explain how to take that and move on to the next. What you really need is someone to work you through this live. (Like someone who has the little pay-per-minute thing on them. I admit I'm new and have no clue who around could do that, but I haven't seen a lot of activity on the accounting forum.) But I can maybe try to give a couple of steps to get your started. I would start by making like a mini income statement based on the changes that will occur with the new machine. I.e. They gave you an increase in sales, an increase in non-depreciation expenses, and an increase in depreciation. (Which you'll have to figure out.) But you also have a decrease in depreciation on the old machine. You don't need a real income statement because you're only interested in the changes. If you do that, you'll then have a change in income before taxes, and from there figure the tax expense. However, the depreciation is only for figuring tax -- it counts for taxable income. But it's not a cash flow, so once you have the net income change (with taxes included), then you must remove the depreciation stuff back out to get back to the actual cash flow. You then need to figure in any other cash changes that are going to happen, things that do not affect the income statement. I don't recall it all, but seems like there were at least 2-3 things like that -- and you have to consider both new machine and old machine changes. What in there affects cash that was not already figured into the mini income statement? You then net all that out to a net cash flow, both per year for anything that will happen over the course of 5 years, and ones that are single one-time cash flows. And you have to figure the present value of those using your rate of return, and compare that to the net investment made. That of course is only a bare basics overview of the process.

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