A firm is considering replacing its computer system with a new one. The new syst

Question

A firm is considering replacing its computer system with a new one. The new system is expected to have an annual operational cost savings of $46,334. The initial cost of the new system is $195,644 and it will last for six years. The 3-year MACRS depreciation method will be used on the new computer system. The current computer system has annual depreciation of $5,368. Both systems will be worthless in six years. The new system requires an initial investment of $3,470 in net working capital, which will be recovered at the end. The marginal tax rate is 0.34 and the annual required return is 0.1. What is the incremental cash flow of this replacement project in year six (the end of the project's life)?

Explanation / Answer

Initial investment = Cost of the new system + Initial investment in net working capital = $ 195,644 + $ 3,470 = $ 199,114

Incremental cash flow in year six = $ 30,580 - $ 5,368 + $ 3,470 = $ 28,682

Year 1 2 3 4 5 6 Annual cost saving $ 46,334 $ 46,334 $ 46,334 $ 46,334 $ 46,334 $ 46,334 Depreciation expense 65,215 86,964 28,975 14,497 - Earnings before taxes ( 18,881) ( 40,630) 17,359 31,837 46,334 46,334 Tax @ 34% - - 5,902 10,825 15,754 15,754 Earnings after tax 11,457 21,012 30,580 30,580 Depreciation expense 65,215 86,964 28,975 14,497 Cash flows 30,580 30,580

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