B6. (Cash flows and NPV for a replacement decision) Andrew Thompson Interests (A
ID: 2666789 • Letter: B
Question
B6. (Cash flows and NPV for a replacement decision) Andrew Thompson Interests (ATI) is using a mechanical switching system that it bought five years ago for $400,000. Thismechanical system is being depreciated straight line to an estimated salvage value of zero over a 10-year life. Thus, the annual depreciation charge is $40,000 and current book value is $200,000. At the end of its life, the actual salvage value is expected to be $25,000. If ATI sold this equipment today, it would fetch $100,000.
ATI is evaluating a new digital switching system that will cost $500,000. The digital
system is depreciated straight line to a zero salvage value over a five-year life. At the end of the five years, ATI expects to sell the system for $150,000. The new digital system should have a favorable impact on operating cash flows, increasing revenues by $100,000 annually and decreasing cash operating expenses by $50,000 annually. The new equipment has no effect on the investment in working capital.
ATI is in the 40% tax bracket and has a 12% cost of capital. Consider each of the following questions assuming that ATI sells the old mechanical switching system and replaces it with the new digital system.
a. What is the net investment?
b. What is the after-tax net operating cash flow for each of the five years?
c. What is the after-tax salvage value?
d. What is the NPV of this investment?
Explanation / Answer
a. Net investment = Total investment - Depreciation Total investment = 500000 Depreciation = (Investment - salvage value) / Useful life = (500000-150000) / 5 = $70,000 Net investment = 500000 - 70000 = $430,000 b. Years Cash inflow Depreciation Cash flow befor tax Tax 40% Net income Net cash flow Year 1 150000 70000 80000 32000 48000 118000 Year 2 150000 70000 80000 32000 48000 118000 Year 3 150000 70000 80000 32000 48000 118000 Year 4 150000 70000 80000 32000 48000 118000 Year 5 150000 70000 80000 32000 48000 118000 Years Cash inflow Depreciation Cash flow befor tax Tax 40% Net income Net cash flow Year 1 150000 70000 80000 32000 48000 118000 Year 2 150000 70000 80000 32000 48000 118000 Year 3 150000 70000 80000 32000 48000 118000 Year 4 150000 70000 80000 32000 48000 118000 Year 5 150000 70000 80000 32000 48000 118000c. Salvage value = Cost of the asset - Depreciation = 500000 - 350000 = $150,000 After tax salvage value = Salvage value - Tax = 150000 - (150000*40%) = 150000-60000 = $90,000 Add: Net income = 48000 * 5 = 240000 = 240000 + 150000 = $390,000 d. Years Cash flow Cost of capital 12% Net cash flow Year 1 118000 0.893 105357.14 Year 2 118000 0.797 94068.88 Year 3 118000 0.712 83990.07 Year 4 118000 0.636 74991.13 Year 5 118000 0.567 66956.37 Present value of cash in flows $425,364 Net present value = Present value of cash in flows - Present value of investment Total inflows = 425364 + 100000 = $525364 Net present value = 525364 - 500000 NPV = $25,364 Years Cash flow Cost of capital 12% Net cash flow Year 1 118000 0.893 105357.14 Year 2 118000 0.797 94068.88 Year 3 118000 0.712 83990.07 Year 4 118000 0.636 74991.13 Year 5 118000 0.567 66956.37 Present value of cash in flows $425,364 Net present value = Present value of cash in flows - Present value of investment Total inflows = 425364 + 100000 = $525364 Net present value = 525364 - 500000 NPV = $25,364
Thank you.... Net investment = Total investment - Depreciation Total investment = 500000 Depreciation = (Investment - salvage value) / Useful life = (500000-150000) / 5 = $70,000 Net investment = 500000 - 70000 = $430,000
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