Replacement project cash flowsThe Minot Kit Aircraft Company

(Replacement project cash? flows)??The Minot Kit Aircraft Company of? Minot, North? Dakota, uses a plasma cutter to fabricate metal aircraft parts for its plane kits. The company currently is using a cutter that it purchased four years ago that has a book value of $70,000 and is being depreciated $17,500 per year over the next 4 years. If the old cutter were to be sold? today, the company estimates that it would bring in an amount equal to the book value of the equipment. The company is considering the purchase of a new automated plasma cutter that would cost $340,000 to install and that would be depreciated over the next 4 years toward a $42,000 salvage value using? straight-line depreciation. The primary advantage of the new cutter is the fact that it is fully automated and can be run by one operator rather than the three employees that are currently required. The labor savings would be $90,000 per year. The firm faces an income tax rate of 29 percent. At the end of the? 4-year project both cutters could be sold at their? end-of-project book value.

a.??The differential operating cash flow savings per year during years 1 through 3 for the new cutter are?

b.??What are the differential operating cash flow savings per year during years 1 through 4 for the new plasma? cutter?

c.??What is the initial cash outlay required to replace the existing plasma cutter with the newer? model?

d.??What does the timeline for the replacement project cash flows for years 0 through 4 look? like?

e.??If the company requires a discount rate of 14 percent for new? investments, should the plasma cutter be? replaced?

Solution

a) Year 1- 3 Cost Savings $90,000.00 Incremental Depreciation = $74,500 - $17,500 $57,000.00 EBIT $33,000.00 Tax @ 29% $9,570.00 Net Income $23,430.00 Add: Depreciation $57,000.00 Operating Cash Flow (OCF) $80,430.00 Per year Depreciation of new machine = ($340,000 - $42,000)/4 years $74,500.00 b) Year 1-4 Cost Savings $90,000.00 Incremental Depreciation = $74,500 - $17,500 $57,000.00 EBIT $33,000.00 Tax @ 29% $9,570.00 Net Income $23,430.00 Add: Depreciation $57,000.00 Operating Cash Flow (OCF) $80,430.00 Per year Depreciation of new machine = ($340,000 - $42,000)/4 years $74,500.00 c) Outflow Cost of new equipment -$340,000.00 Net after-tax amount received for the old cutter $70,000.00 Initial Investment -$270,000.00 since the salvage value and book values are the same, there will be no tax consequence from this sale. d) 0 1 2 3 4 -$270,000.00 $80,430.00 $80,430.00 $80,430.00 $122,430.00 The firm sells the cutter for $42,000, its book value; there is therefore no tax effect from this sale. Year 4 = $80430 + $42000 $122,430.00 e) Year 0 1 2 3 4 CashFlow -$270,000.00 $80,430.00 $80,430.00 $80,430.00 $122,430.00 PV @ 14% 1 0.8772 0.7695 0.6750 0.5921 Present Value -$270,000.00 $70,552.63 $61,888.27 $54,287.96 $72,488.39 NPV -$10,782.75 Minot should reject this replacement opportunity as NPV is Negative . It is better off keeping the old cutter.