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1. Topsider Inc. is considering replacing an old leather-cutting machine with a new one that will reduce costs and increase sales. 2. The initial cash outflow is $13,820 which includes the cost of the new machine minus the salvage value of the old machine. 3. Operating cash flows are positive each year, ranging from $5,252 to $6,956, as the new machine reduces costs and increases revenues. 4. Terminal cash flows in year 3 are $3,017.60 including the salvage value of the new machine. The NPV of the project is $2,056.39 and the IRR is 24.465734%.

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164 views3 pages

Capbudhint

1. Topsider Inc. is considering replacing an old leather-cutting machine with a new one that will reduce costs and increase sales. 2. The initial cash outflow is $13,820 which includes the cost of the new machine minus the salvage value of the old machine. 3. Operating cash flows are positive each year, ranging from $5,252 to $6,956, as the new machine reduces costs and increases revenues. 4. Terminal cash flows in year 3 are $3,017.60 including the salvage value of the new machine. The NPV of the project is $2,056.39 and the IRR is 24.465734%.

Uploaded by

Imran Idris
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Relevant Capital Budgeting Cash Flows are Future, Operating, Incremental, Aftertax, Cash Flows Initial Cash Flows:

1. Cost of new equipment including shipping and installation (this is the number that will be depreciated (depreciable basis)), always a cash outflow (-). 2. Change in working capital (increases in assets are a use (-) of cash, increases in liabilities are a source (+) of cash). 3. Tax impact of new equipment (not tested in MBA 8622). Replacement only, 4. Salvage Value of Old Equipment, always a cash inflow (+). Replacement only, 5 Tax impact of Old Equipment (= ((Book Value Salvage Value)*tax rate)), may be inflow or outflow. Operating Cash Flows, a modified income statement for each year of the Project Change in + Sales - Variable Operating Expenses - Fixed Operating Expenses - Depreciation (depreciable basis * depreciation percentage) = EBIT - Taxes = NOPAT + Depreciation = Operating Cash Flows If a replacement problem, use net changes for Sales, Variable Operating Expens es, Fixed Operating Expenses and Depreciation. For example, in a replacement problem, Depreciation = Depreciation on New Equipment Depreciation of old Equipment. Terminal Cash Flows 1. Salvage Value of the now old New Equipment, always a cash inflow. 2. Tax impact of Old Equipment = ((Book Value Salvage Value) * tax rate). Note, book value = purchase price accumulated depreciation. If you sell machine for more than book value, this is a profit that creates a tax liability or a cash outflow (-). If you sell the machine for less than book value, this is a loss/reduction in profits that creates a tax credit or a cash inflow (+). 3. Recovery of Working Capital (the exact same number as line 2 in Initial Cash Flows with the opposite sign). Replacement Problems Only, 4. Opportunity Cost of not receiving Salvage Value for Old equipment, which is always a cash outflow (-). This is because if you sell the old machine at time 0 (a cash inflow) you cannot later sell it at the end of the project. Thus we record the selling price we do not receive as a negative number. Replacement Problems Only, 5. Opportunity Cost of tax impact of not receiving Salvage Value for Old Equipment = - ((Book Value-Opportunity Salvage )*tax rate). Note the negative sign prior to book value, since line 4 is always a cash outflow, we reverse the sign for the tax impact.

Consider the following Replacement Problem: Topsider Inc. is considering the purchase of a new leather-cutting machine to replace an existing machine that has a book value of $3,000 and can be sold for $1,500. The old machine is being depreciated to $0 on a straight- line basis. The old machines estimated salvage value 3 years from now is $500. The new machine will reduce fixed costs (before taxes) by $7,000 per year. The new machine will improve quality, thus increasing our leather sales from $15,000 to $17,000 per year. Variable Costs are 50% of Sales. The new machine has a 3- year life, it costs $14,200, and it can be sold for an expected $2,000 at the end of the third year. Because of the new sales, we will increase our inventory by $1,000, our accounts receivable by $1,500, and our accounts payable by $780. Our tax accountant has told Topsider that the new machine would be depreciated using the following depreciation schedule; Year 1 @ 33%, Year 2 @ 45%, Year 3 @ 15%, and Year 4 @ 7% Assume a 40 percent tax rate and a cost of capital of 16 percent. Typically, you will be asked 3-5 of the below questions on the Final Exam: 1. 2. 3. 4. 5. What is the Initial Cash Flow? What is the Operating Cash Flows in Year 2? What is the Terminal Cash Flow (a.k.a. non-operating) in year 3? What are the total cash flows in Year 3? What is the NPV and/or IRR of the project?

To answer the above questions, first solve the entire problem, then answer the questions. Initial Cash Flows: 1. Cost of New Equipment = -$14,200 2. Change in working Capital = -$1,720 (=-1000-1500+780) 3. Tax Impact of New Equipment = 0 4. Salvage Value of Old Equipment = +$1,500 5. Tax Impact of Old Equipment = +600 (=((3000-1500)*40%)) Total Initial Cash Flows = -$13,820 Operating Cash Flows Years 1-3 Year 1 New Sales 17000 Old Sales 15000 =Net Sales Change +2000 Fixed Costs +7000 Net Variable Costs -1000 New Deprecation Old Depreciation =Net Depreciation =EBIT -4686 +1000 -3686 +4314

Year 2 17000 15000 +2000 +7000 -1000 -6390 +1000 -5390 +2610

Year 3 17000 15000 +2000 +7000 -1000 -2130 +1000 -1130 +6870

-taxes @ 40% -1725.6 =NOPAT +2588.4 +Net Depreciation +3686 =Operating Cash Flow+6274.40

-1044 +1566 +5390 +6956

-2748 +4122 +1130 +5252

Terminal Cash Flows: 1. Salvage of New Machine = +2000 2. Tax impact of New Machine = -402.40 = (994 {14200*7% or [14200 (14200*93%)]}-2000)*40%) 3. Reversal of working capital =+1720 4. Opportunity Cost of old equipment = -500 5. Tax impact of old machine opportunity costs = +200 = - ((0-500)*40%) Terminal Cash Flows = +3017.60 Thus our timeline is Year Initial Operating Terminal Totals

0 -13820

1 +6274.40

2 +6956

3 +5252 +3017.60 +8269.60

-13820

+6274.40

+6956

NPV@16% = $2056.389356 IRR=24.465734%

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