CC Company is considering a new assembly line to replace the existing assembly l
ID: 2744957 • Letter: C
Question
CC Company is considering a new assembly line to replace the existing assembly line. The existing assembly line was installed 2 years ago at a cost of $90,000; it was being depreciated under the straight-line method. The existing assembly line is expected to have a usable life of 4 more years. The new assembly line costs $120,000; requires $8,000 in installation costs and $5,000 in training fees; it has a 4-year usable life and would be depreciated under the straight-line method. The new assembly line will increase output and thereby raises sales by $10,000 per year and will reduce production expenses by $5,000 per year. The existing assembly line can currently be sold for $15,000. To support the increased business resulting from installation of the new assembly line, accounts payable would increase by $5,000 and accounts receivable by $12,000. At the end of 4 years, the existing assembly line is expected to have a market value of $4,000; the new assembly line would be sold to net $15,000 before taxes. Finally, to install the new assembly line, the firm would have to borrow $80,000 at 10% interest from its local bank, resulting in additional interest payments of $8,000 per year. The firm pays 34% taxes and its shareholders require 10% return.
(A) (6 points) What is the initial cash outlay for this replacement project?
(B) (5 points) What is the operating cash flow of the project?
(C) (5 points) What is the terminal cash flow of the project?
(D) (4 points) Should you replace the existing assembly line? Provide all the details.
Explanation / Answer
A. Initial cash outlay = Cost of the assembly line + Installation costs + Training fees + Increase in working capital - salvage value of existing assembly line = $ ( 120,000 + -8,000 + 5,000 + 7,000 - 15,000) = $ 125,000
B. Operating cash flow:
C. Terminal cash flow = After tax salvage value + Release of working capital = $ 15,000 x ( 1- T) + 7,000 = $ 16,900
D. NPV at 10% = Operating cash flows x PVIFA 10%, 4 years + Terminal cash flows x PVIF 10%, 4th year - Initial investment = $ (14,405 x 3.1699 + 16,900 x 0.6830 - 125,000 ) = $ (67,795)
The existing assembly line should not be replaced, as the net present value of the investment in the new assembly line is negative.
$ Increase in sales 10,000 Reduction in production expenses 5,000 Incremental revenues 15,000 Incremental depreciation expenses 13,250 Incremental operating income before taxes 1,750 Tax @ 34% 595 Incremental operating income 1,155 Operating cash flows ( Incremental operating income + Incremental depreciation) 14,405