New York Pizza is considering replacing an existing oven with a new, more sophisticated oven. The old oven was purchased three years ago at a cost of $20,000, and this amount was being depreciated under MACRS using a five-year recovery period. The oven has five years of usable life remaining.
The new oven being considered costs $30,500, requires $1,500 in installation costs, and would be depreciated under MACRS using a five-year recovery period. The old oven can currently be sold for $22,000, without incurring any removal or cleanup costs. The firm pays taxes at a rate of 40 percent on both ordinary income and capital gains.
The revenues and expenses (excluding depreciation) associated with the new and the old machines for the next five years are given in the following table.
| |
New Oven |
Old Oven |
| Year |
Revenue |
Expenses (Excluding depreciation) |
Revenue |
Expenses (Excluding depreciation) |
|
1
|
$ 300,000
|
$ 288,000
|
$ 270,000
|
$ 264,000
|
|
2
|
300,000
|
288,000
|
270,000
|
264,000
|
|
3
|
300,000
|
288,000
|
270,000
|
264,000
|
|
4
|
300,000
|
288,000
|
270,000
|
264,000
|
|
5
|
300,000
|
288,000
|
270,000
|
264,000
|
a. Calculate the initial cash outflow associated with replacement of the old oven by the new one.
b. Determine the incremental cash flows associated with the proposed replacement. Be sure to consider the depreciation in year 6.
c. Depict on a time line the relevant cash flows found in parts (a) and (b), associated with the proposed replacement decision.