Question: A firm is considering the buy of a new equipment to replace the one that is currently in use. It has gathered the following data on each of these equipments:
The equipment currently in use was originally purchased two years ago for dollar 40,000. It is being depreciated under the modified accelerated cost recovery system [MACRS] using a five year recovery period, and has three years of usable life remaining. The current equipment can be sold today to net $42,000 after removal & cleanup costs. However, in 3 years [at the end of three year] the market value of the old equipment will be zero. The firm's earnings before depreciation, interest & taxes [EBDIT] are expected to be dollar 70,000 for each of the next three years if the old equipment is kept in use.
The new equipment can be purchased at a price of $140,000 & requires $10,000 to install. It has a three year usable life & will be depreciated under the MACRS using a three year recovery period. If the new equipment is acquired, the investment in accounts receivable will be expected to rise by $10,000, the inventory investment will increase by $25,000, & accounts payable will increase by $15,000. At the end of three years, the new equipment could be sold to net $35,000 before taxes. Earnings before depreciation, interest & taxes (EBDIT) are expected to be as follows with the new equipment:
|
Year
|
EBDIT
|
|
1
|
$120,000
|
|
2
|
$130,000
|
|
3
|
$130,000
|
The firm is subject to a 40% tax rate.
[A] Determine the initial investment associated with the proposed replacement decision.
[B] Compute the incremental operating cash inflows for Years 1 to 4 associated with the proposed replacement. [Note: Only depreciation cash flows must be considered in Year 4].
[D] Compute the terminal cash flow associated with the proposed replacement decision. [Note: This is at the end of Year 3].
[E] Depict on a time line the relevant cash flows found in parts a, b, & c that are associated with the proposed replacement decision, assuming it is terminated at the end of Year 3.