CC Company is considering a new assembly line to replace the existing assembly l

Question

CC Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 2 years ago at a cost of $90,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 4 more years. The new assembly line costs $120,000; requires $8,000 in installation costs and $5,000 in training fees; it has a 4-year usable life and would be depreciated under the straight-line method. The new assembly line will increase output and thereby raises sales by $10,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $15,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $12,000. At the end of 4 years, the existing assembly line is expected to have a market value of $4,000; the new assembly line would be sold to net $15,000 before taxes. Finally, to install the new assembly line, the firm would have to borrow $80,000 at 10% interest from its local bank, resulting in additional interest payments of $8,000 per year. The firm pays 34% taxes and its shareholders require 10% return.

(A)    (6 points) What is the initial cash outlay for this replacement project?

(B)    (5 points) What is the operating cash flow of the project?

(C)    (5 points) What is the terminal cash flow of the project?

(D)    (4 points) Should you replace the existing assembly line? Provide all the details.

Explanation / Answer

(A) INITIAL CASH OUTLAY: cost of the new assembly line 120000 cost of installation 8000 training fees 5000 PV of tax shield of 34% on trg fees at year end @ 34% -1574 (5000*0.34/1.0803) increase in net working capital (12000-5000) 7000 salvage value of old assembly line 15000 tax shield of 34% on loss on sale of old line (34% of 60000-15000) -15300 138126 (B) OPERATING CASH FLOW: yearly increase in sales 10000 yearly savings in production costs 5000 Less: depreciation (128000-15000)/4 28250 increase in operating profit before tax -13250 Tax at 34% -4505 incremental operating profits after tax -8745 add: depreciation 28250 incremental operating cash flow 19505 [C] TERMINAL CASH FLOW: Salvage value of the new assembly line 15000 (gain on sale taken as 0, as BV = $15000) Salvage value lost on the old assembly line -2640 (less tax of 34% assuming old line is depreciated to zero) Release of net working capital 7000 Terminal cash flow 19360 [D] NPV: PV of annual operating cash flows = 19505*3.3099 64560 (annuity discounted at 8.03%) PV of terminal cash flow = 19360*.7342 14214 (discounted at 8.03%) PV of cash inflows 78774 Less: Initial cash flow 138126 NPV -59353 As the NPV of the replacement is negative the existing assembly line should not be replaced. Calcualtion of WACC: after tax cost of debt = 10*0.66 = 6.6% cost of equity = 10% given weight of debt = 80000/138126 = 0.5792 weight of equity = 58126/138126 = 0.4208 WACC = 6.6*0.5792+10*0.4208 = 3.82+4.21=8.03%

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