Computation of the projects free cash flows
A firm is considering the purchase of a new machine to replace the one that is currently in use. It has gathered the following information on each of these machines:
Current Machine: The machine currently in use was originally purchased 2 years ago for $40,000. It is being depreciated under the modified accelerated cost recovery system (MACRS) using a 5-year recovery period, and has 3 years of usable life remaining. The current machine can be sold today to net $42,000 after removal and cleanup costs. However, in 3 years (at the end of Year 3) the market value of the old machine will be zero. The firm\'s earnings before depreciation, interest and taxes (EBDIT) are expected to be $70,000 for each of the next 3 years if the old machine is kept in use.
New Machine: The new machine can be purchased at a price of $140,000 and requires $10,000 to install. It has a 3-year usable life and will be depreciated under the MACRS using a 3-year recovery period. If the new machine is acquired, the investment in accounts receivable will be expected to rise by $10,000, the inventory investment will increase by $25,000, and accounts payable will increase by $15,000. At the end of 3 years, the new machine could be sold to net $35,000 before taxes. Earnings before depreciation, interest and taxes (EBDIT) are expected to be as follows with the new machine:
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. Calculate 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).
c. Calculate the terminal cash flow associated with the proposed replacement decision. (Note: This is at the end of Year 3).
d. Depict on a time line the relevant cash flows found in parts a, b, and c that are associated with the proposed replacement decision, assuming it is terminated at the end of Year 3.