Trident Limited is considering replacing an old machine. The new machine is expe

Question

Trident Limited is considering replacing an old machine. The new machine is expected improve output which would increase additional net cash flows of $100, 000 (before depreciation, taxes and the savings mentioned in the following paragraph). The new machine will also require one less part-time employee which would result in pre-tax savings of $35,000 per year. Maintenance costs are also expected to be substantially lower with an annual pre-tax saving of $15,000 per year. Average accounts receivable will increase from $45,000 to $58.000 while accounts payable will increase by $8.000. Inventory is also expected to increase by $22.000. Assume that these changes are expected to occur immediately. The old machine was originally purchased for $250.000 and has a book value of $50, 000. The old machine could be sold today for $35.000 but if retained and operated for a further five years it would only be worth $10, 000. The new machine currently costs $450, 000 and requires $50.000 installation costs. In 5 yearsprime time the machine could be sold for $170, 000. New Zealand taxation rules allow depreciation on a straight-line basis over 10 years; however management reports to shareholders using the straight line method over 20 years. The company tax rate is 28%. Calculate the initial investment associated with the proposed replacement decision. Calculate the incremental operating cash flow in year 1 associated with the proposed replacement decision. Calculate the terminal value associated with the proposed replacement decision.

Explanation / Answer

1.calculation of initial investment

cost of new machine 450000

(+) installation charges 50000

Gross value 500000

(-) sale vale of old machine (35000)

Initial investment 465000

2. calculation of incremental cashflow

Increase in revnue 100000

(+) pretaxsavings 35000

(+) reduction in maintenance cost 15000

(+) increase in B-R 13000

(+) reduction in loss on

sale of machine 40000

(-) increase in B-P (8000)

(-) inventory cost (22000)

Earnings before tax and

Depreciation 173000

(-) additional depreciation (125000)

Earnings before tax 48000

(-) tax @ 28% (13440)

Earnings after tax 34560

(+) additional depreciation 125000

Cash flow after tax 159560

3. Terminal value of old machinery

Year 1 2 3 4 5

opng bal 250000 225000 200000 175000 150000

(-) Dep (25000) (25000) (25000) (25000) (25000)

clsng bal 225000 200000 175000 150000 125000

(-)salvage

value (10000)

loss on sale 115000

Terminal value of new depreciation

Year 1 2 3 4 5

opngbal 500000 450000 400000 350000 300000

(-) Dep (50000) (50000) (50000) (50000) (50000)

clsng bal 450000 400000 350000 300000 250000

(-) salvage

value (175000)

loss on sale 75000

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