Integrative-Determining relevant cash flows Lombard Company is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The existing grinder was purchased 2 years ago at an installed cost of $60,000; it was being depreciated under MACRS using a 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 a 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, accounts 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 is expected to have a market value of zero; the new grinder would be sold to net $29,000 after removal and cleanup costs and before taxes. The firm pays taxes at a rate of 40% on both ordinary income and capital gains. The estimated profits before depreciation and taxes over the 5 years for both the new and the existing grinder are shown in the following table. (Table 3.2 on page 100 contains the applicable MACRS depreciation percentages.)
|
TABLE 3.2
|
|
Rounded Depreciation
Percentages by Recovery Year
Using MACRS for First Four
Property Classes
|
|
Percentage by recovery yeara
|
|
Recovery year
|
3 years
|
5 years
|
7 years
|
10 years
|
|
1
|
33%
|
20%
|
14%
|
10%
|
|
2
|
45
|
32
|
25
|
18
|
|
3
|
15
|
19
|
18
|
14
|
|
4
|
7
|
12
|
12
|
12
|
|
5
|
|
12
|
9
|
9
|
|
6
|
|
5
|
9
|
8
|
|
7
|
|
|
9
|
7
|
|
8
|
|
|
4
|
6
|
|
9
|
|
|
|
6
|
|
10
|
|
|
|
6
|
|
11
|
___
|
___
|
___
|
4
|
|
Totals
|
100%
|
100%
|
100%
|
100%
|
|
Profits before
depreciation and taxes
|
|
Year
|
New grinder
|
Existing grinder
|
|
1
|
$43,000
|
$26,000
|
|
2
|
43,000
|
24,000
|
|
3
|
43,000
|
22,000
|
|
4
|
43,000
|
20,000
|
|
5
|
43,000
|
18,000
|
a. Calculate the initial investment associated with the replacement of the existing grinder by the new one. b. Determine the incremental operating cash inflows associated with the proposed grinder replacement. (Note: Be sure to consider the depreciation in year 6.)
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 flows associated with the proposed grinder replacement decision.