Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are ha

Question

Duddy Kravitz owns the Saint Viateur Bagel store. His world famous bagels are hand rolled, boiled in honey-water and baked in a wood-burning oven. The store sells 5,000 bagels per day and is open 365 days of the year. The bagels are so popular that, on weekends, the customer line-up runs half-way down the block. Uncle Benjy thinks that the wood-fired oven should be replaced by a modern gas oven, which would reduce costs by $0.02 per bagel. A new oven would cost $105,000. Duddy is considering Uncle Benjy's idea, but he only plans to be in business for another two years. The bagels are sold for $0.75 each. The cost of producing each bagel with the wood-burning oven is $0.50 which includes labour and raw materials. The current oven was purchased thirty years ago for $20,000. It could be sold today for $5,000 and will be worth $3,000 in two years. A new oven costs $105,000 today and could be sold for $55,000 in two years. Duddy's cost of capital is 9%. Assume that investment cash flows occur immediately, and that sales and production costs occur at the end of the year. Assume that both ovens are classified as 10-year property and depreciated using the MACRS system. The tax rate is 35%. What is the cash flow from the replacement project for year 1? a.$10,500 b.$16,900 c.$26,000 d.$27,400 e.$36,500

Explanation / Answer

It is a capital investment decision. Duddy Kravitz is selling baggels ( a food). It is maufactured by using a wood burning woven. It has been planned to replace it by a new woven. Old one was purchased 30 years back at $20,000. Now it can be sold at $5,000. Duddy has planned to remain in this business for another 2 years. If the old one is still used, then after two years it can be sold at $2,000. Cost of new woven is $105,000. Its resale value after two years is $ 55,000.

From above informations, two incremental cash flows can be ascertained. They are as followes:

1. If the replacement decision is taken, you have to pay immediately $105,000. A portion of it will be recovered by selling the old one. It is $5,000. Thus net incremental cash outflow at time zero is $105,000-$5,000=$100,000

2. After two years you will get $55,000 by selling new woven. If it is not purchased, then old one is sealable at $3,000. So incremental cash flow after 2 years is $55,000-$3,000=$52,000

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Next consider incremental cash inflow from trading activities. If replacement is mde $0.02 cost is saved per unit. Daily sale is 5,000 units. In 365 days total sale is 5,000x365=1,825,000. Multiply it by $0.02 to get incremental cash from cost saved. It is $36,500 as shown in table (point 5) below.

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From this incremental revenue deduct depreciation, to get incremental taxable revenue. You have to apply MACRS rate. It is based on life of the asset Here life of new woven is 10 years. So depreciation is applicable for 11 years. In this method depreciation will be calculated from the middle of first year and will end at middle of 11th year. So 50% of the calculated rate will be applicable here.

For 10 years life depreciation rate per year will be 10%. MACRS doubles it. So for first year, it is 20%. Now take it for 6 months. Rate is again coming down to 10%.

In second year reduced balance is 90%. Take 20% of it. The percentage is 90*0.20=18%. It is the rate applicable for year 2.

After deducting tax, add back depreciation to get net incremental cash flow from operating activities. Finally add salavage inflows to get total cash flow. The detailed calculations are shown in the table below:

Consider row 13 of the table. It indicates net cash flow. In year 1, it is $27,400. Thus option (d) is correct.

(Note: If you multiply cash flows by discounted present value of $1 at 9% rate, you will get present value of cash flows for each year. Add them to get net present value. Here it is negative. So replacement should not be made.)

Statement showing detailed calculation of cash flows Details Year 0 Year 1 Year 2 1. Cost of new machine -105,000 2. Sale of old machine 5,000 3. Incremental cash outflow [1-2] -100,000 4. Quantity sold 1825000 1825000 5. Incremetal cash flow @$0.02 36500 36500 6. Depreciation rate [MACRS] 10% 18% 7. Depreciation [1*6 -10500 -18900 8. Net incremental cash flows [5+7] 26000 17600 9. Tax 35% 9100 6160 10. Incremental revenue after tax [8-9] 16900 11440 11. Incremental cash flow from operation                                               [10+7] 27400 30340 12. Incremetal salvage [55,000-3,000] 52,000 13. Total incremental cash flow 27400 82340 14. discount factor 0.91743 0.84168 15. Present value of cash flows 25137.6 69303.9 16. NPV -5,558

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