Two years ago our company bought equipment for $1 million that has been deprecia

Question

Two years ago our company bought equipment for $1 million that has been depreciated straight line over a five-year life. Key points to consider: The equipment has a current market value of $300,000. More efficient equipment can be purchased today for $3 million and is expected to last 5 years (economic life), at which time its anticipated salvage value would be $300,000. However, the new equipment would be depreciated straight line over only four years to a zero salvage value. Our company would realize a $1,000,000 per year operating cost savings by replacing the old equipment with the new equipment. Also, the Net Working Capital Requirement would decrease by $75,000 as soon as the equipment is purchased, but would increase when it is sold at the end of its economic life (5 years). The marginal tax rate is 30%. Required: Identify the relevant cash flows for this project.

Explanation / Answer

All Amounts in $ Cash Flows for the Project Year(s) Cash Outflows -3000000 0 Decrease in Working Capital 75000 0 Operating Cost savings per year for 5 years 5000000 1 to 5 Less : Tax Impact @ 30% 1500000 1 to 5 Post Tax Cash Inflows for 5 years 3500000 1 to 5 Salvage Value of equipment 300000 5

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