Lolonyo Company is contemplating the purchase of a new high-speed widget grinder

Question

Lolonyo Company is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The new grinder costs GHs 105,000 and requires GHs 5,000 in installation costs; it has a 3-year unabie life and would be depreciated under MACRS using a S-year recovery period. The cost of the existing was 70,000 and it was being depreciated under the S-year recovery period. The existing machine has been in use for the past 3 years and Lolonyo can currently sell the existing grinder for GHs 7,000 without incurring any removal or clean-up costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by GHs 40,000, inventories by GHs 30,000, and accounts payable by GHs 58,000. Ar the end of 5 years the new grinder would be sold to net als 29,000 before taxes. The firm is subject to a 40% tax rate. The estimated eamings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the following table. machine Existing Grinder (GHS) 23,000 23,000 23,000 23,000 23,000 Year New Grinder (GHS) 83,000 93,000 73,000 63,000 53,000 Use the Table containing the applicable MACRS depreciation percentages below Table containing the applicable MACRS depreciation percentages Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property classes Percentages by Recovery year 5 Year 20 32 Recovery2 year Year 7 Year 14 25 18 12 10 Years 10 18 14 12 45 15 12 12 10 1I Required: (a) Calculate the initial investment associated with the replacement of the existing grinder by the new one. (b) Determine the incremental operating cash inflows associated with the proposed grinder (e) Determine the terminal cash flow expected at the end of year 5 from the proposed grinder repla (d) Apply the Net Present Value (NPV) and the Internal Rate of Return (IRR) rules to assess the viabilit replacement. or otherwise of the proposed replacement project.

Explanation / Answer

a. Initial investment associated with the replacement of the existing machine: GH 127,320

b. Incremental Operating Cash Flows:

c. Terminal cash flows at the end of Year 5: 31,600

Book value of new grinder = 110,000 x 5% = 5,500.

Gain on salvage = 29,000 - 5,500 = 23,500.

Tax effect of gain on salvage = 23,500 x 40 % = 9,400.

After tax salvage proceeds = 29,000 - 9,400 = 19,600.

Terminal cash flows = Working capital recovered + After tax salvage proceeds = 12,000 + 19,600 = 31,600.

GH Installed Cost of the New Machine 110,000 Income tax refund on loss on salvage existing grinder 5,320 Increase in net working capital 12,000 Total Initial Investment 127,320

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