Task: Integrative - Determining relevant cash flows.
Lombard Co is contemplating the purchase of a new high-speed widget grinder to replace the exiting grinder. The existing grinder was purchased 2 years ago at an installed cost of $60,000 it was being depreciated under MACRS using 5 year recovery period.
The existing grinder is expected to have a usable life of 5 more years. The new grinder costs $105,000 and requires $5,000 in installation costs, it has a 5 year usable life and would be depreciated under MACRS using 5 year recovery period. Lombard can currently sell the existing grinder for $70,000 without incurring any removal or cleanup costs.
To support the increased business resulting from purchase of the new grinder, Account Receivable would increase by $40,000 Inventories by $30,000 and Accounts Payable by $58,000 at the end of 5 years, the existing grinder would have a market value of Zero, the new grinder would be sold to net $29,000 after removal and cleanup costs and before Tax's.
The firm is subject to a 40% Tax Rate. The estimated Earning Before Depreciation, Interest, and Taxes over the 5 years for both the new and existing grinder are shown in following table) contains the applicable MACRS Depreciation Percentage)
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Percentage by recovery year |
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Recovery Year |
3 YEARS |
5 Years |
7 Years |
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Earnings Before |
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1 |
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33% |
20% |
14% |
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Dep, Interest, and Taxes |
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2 |
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45 |
32 |
25 |
| Year |
New Grinder |
Existing Grinder |
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3 |
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15 |
19 |
18 |
| 1 |
$43,000 |
$26,000 |
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4 |
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7 |
12 |
12 |
| 2 |
43,000 |
24,000 |
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5 |
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12 |
9 |
| 3 |
43,000 |
22,000 |
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6 |
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5 |
9 |
| 4 |
43,000 |
20,000 |
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| 5 |
43,000 |
18,000 |
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A: Calculate the Initial investment associated with the replacement of the existing grinder by the new one.
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| Cost of new grinder |
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$105,000 |
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| Install cost |
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5,000 |
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Book value on old grinder: |
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| Total cost for new grinder |
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$110,000 |
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int 1 & 2 yr @5yr% times existing grinder |
[1 - (0.20 + 0.32)] * $60,000 = $28,800 |
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sell existing minus |
$70,000 - $28,800 = $41,200 gain sale of grinder |
| After-tax proceeds for old grinder |
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$60,000 - 28,800 = 31,200 |
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| From sale of old grinder |
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-70,000 |
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difference from sale of grinder and tax rate |
$31,200 recaptured dep * 0.40 = $12,480 |
| Tax on sale of old grinder: 31,200 *0.40 = 12,480 + 4,000 ( Capital gain * 40%) = 16,480 |
16,480 |
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existing grinder was 70,000, sell for 60,000 = gain of 10,000 |
$10,000 Capital gain * 0.40 = $4,000 |
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-53,520 |
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Total tax on sale of grinder = $16,480 |
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| Change in capital: curent assets 40,000 + 30,000= 70,000-58,000 liabilities, |
12,000 |
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| Initial investment |
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$68,480 |
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B: Determine the Incremental operating cash inflows associated with the proposed grinder replacement. (Note: Be sure to consider the Depreciation in year 6)
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Calculation Operatin Cash Inflows |
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| Year |
Profits b4 Dep & Taxs |
Depreciation |
Net Profit b4 Taxes |
Taxes |
Net Profits after Taxes |
Operating Cash Inflows |
| New Grinder |
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| 1 |
$43,000 |
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$22,000 |
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| 2 |
43,000 |
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35,200 |
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| 3 |
43,000 |
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| 4 |
43,000 |
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| 5 |
43,000 |
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| 6 |
0 |
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| Existing Grinder |
| 1 |
$26,000 |
| 2 |
24,000 |
| 3 |
22,000 |
| 4 |
20,000 |
| 5 |
18,000 |
| 6 |
0 |
C: Determine the Terminal cash flow expected at the end of year 5 from the proposed grinder replacement.
D: Depict on a time line the relevant cash flow associated with the proposed grinder replacement decision.