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Company A is trying to determine whether to replace an existing asset. The proposed asset has a...

Question:

Company A is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using the simplified straight-line method. The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life. The existing asset was originally purchased three years ago for $25,000, has a remaining life of 5 years, and is being the asset depreciated using the simplified straight-line method. The expected salvage value at the end of the asset's life is $5,000; however, the current sale price of the existing asset is $20,000, and it's current book value is $15,625. Company A is in the 34% marginal tax bracket and has a required rate of return of 12%.

a. What is the initial cost of the project?

b. What are the free cash flows generated by this project each other?

c. What is the terminal cash flow?

d. Calculate the value of this project. Should you replace the existing asset?

Terminal Cash Flow:

Terminal cash flow refers to the total net cash flow generated from the project at the end of the project. There is two cash flow associated with terminal cash flow that is the net proceeds from selling the asset and recoupment of working capital.

Answer and Explanation:

Given data:

Purchase price of asset = $50,000

Installation costs = $3,000

Life = 5 years

Increase in sales = $17,000

Non-depreciation expenses = $2,000 annually

Working capital investment = $1,500

Sales value at end of life = $6,000

Purchased assets (3 year ago) = $25,000

Salvage value = $5,000

Sales value existing asset = $20,000

Book value = $15,625

Tax bracket = 34%

Required rate of return = 12%

Computing:

Cost of proposed asset = Purchase price of asset + Installation cost

Cost of proposed asset = 50,000 + 3,000

Cost of proposed asset = $53,000


Gain on sale of existing asset = Sales value existing asset - Book value

Gain on sale of existing asset = 20,000 - 15,625

Gain on sale of existing asset = $4,375


Tax on gain on sale of existing asset = Gain on sale of existing asset * Tax bracket

Tax on gain on sale of existing asset = 4,375 * 34%

Tax on gain on sale of existing asset = 4,375 * 0.34

Tax on gain on sale of existing asset = $1,487.50


Proceeds from sale of existing asset = Sales value existing asset - Tax on gain on sale of existing asset

Proceeds from sale of existing asset = 20,000 - 1,487.50

Proceeds from sale of existing asset = $18,512.50


Net initial cost of project = Cost of proposed asset + Working capital investment - Proceeds from sale of existing asset

Net initial cost of project = 53,000 + 1,500 - 18,512.50

Net initial cost of project = $35,987.50


b.

Net operating income = Increase in sales - Non-depreciation expenses

Net operating income = 17,000 - 2,000

Net operating income = $15,000


Net income after taxes = Net operating income * (1 - Tax bracket)

Net income after taxes = 15,000 * (1 - 34%)

Net income after taxes = 15,000 * (1 - 0.34)

Net income after taxes = $9,900


{eq}Annual \ depreciation \ on \ proposed \ asset \ = \ \dfrac{Cost \ of \ proposed \ asset \ - \ Sales \ value \ at \ end \ of \ life}{Life} \\ Annual \ depreciation \ on \ proposed \ asset \ = \ \dfrac{53,000 \ - \ 6,000}{5} \\ Annual \ depreciation \ on \ proposed \ asset \ = \ \dfrac{47,000}{5} \\ Annual \ depreciation \ on \ proposed \ asset \ = \ \$9,400 {/eq}


Tax savings on depreciation expense = Annual depreciation on proposed asset * Tax bracket

Tax savings on depreciation expense = 9,400 * 34%

Tax savings on depreciation expense = 9,400 * 0.34

Tax savings on depreciation expense = $3,196


Free cash flows = Net income after taxes + Tax savings on depreciation expense

Free cash flows = 9,900 + 3,196

Free cash flows = $13,096


c.

Book value of proposed asset at the end of 5 years = Cost of proposed asset - (Annual depreciation on proposed asset * Life)

Book value of proposed asset at the end of 5 years = 53,000 - (9,400 * 5)

Book value of proposed asset at the end of 5 years = $6,000


Terminal cash inflow = Sales value at end of life + Working capital investment

Terminal cash inflow = 6,000 + 1,500

Terminal cash inflow = $7,500


d.

Year Cash flows (A) Present value factor @ 12% (B) Present value of cash flows ((C) = (A) * (B))
0 -35,987.50 1 -35,987.50
1 13,096 0.8929 11,693.42
2 13,096 0.7972 10,440.13
3 13,096 0.7118 9,321.73
4 13,096 0.6355 8,322.51
5 13,096 0.5674 7,430.67
5 7,500 0.5674 4,255.50


Net present value = 11,693.42 + 10,440.13 + 9,321.73 + 8,322.51 + 7,430.67 + 4,255.50 - 35,987.50

Net present value = 51,463.96 - 35,987.50

Net present value = $15,476.46


Learn more about this topic:

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Project Cash Flow: Analysis & Examples

from Finance 101: Principles of Finance

Chapter 10 / Lesson 1
23K

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