Example of replacement of assets, Finance Basics

Example of Replacement of Assets

Estate Developers purchased a machine five years ago on a cost of £7,500.  The machine had a probable economic life of 15 years at the moment of purchase and a zero estimated salvage value at the ending of 15 years.  It is being depreciated on a straight line origin and presently has a book value of £5,000.  The Financial Manager has conducted a feasibility study aimed at acquiring a new machine for £12,000 and is depreciated over its 10 years useful life.  The new machine will expand sales from of £10,000 to of £11,000 per annum and will decrease labor and materials usage enough to cut operating cost from £7,000 to £5,000.  The salvage value of the new machine is £2,000 at the ending of useful life.  The modern market value of the old machine is of £1,000 and tax is 40 percent. The firms cost of capital is 10 percent.  The financial manager wishes to create a decision on whether to replace the old machine along with a new one and he seek your held.

N.B.The decision to replace takes into account as given:

a) Add up the present value of the expected salvage value to the P.V. of the incremental cash flow.

b) Verify the incremental cash flows.

c) Approximation the actual cash outlay attributable to the new machine

d) Calculate the NPV of incremental cash flows.

e) Ascertain whether the NPV or total present value is positive or whether the IRR or internal rate of return exceeds the cost whether in case invest if it's positive.

Solution

a)      Initial capital for new machines                                                  £

          Cash price of new machine                                                        12,000

          Less market value of old machine                                              (1,000)

          Less tax shield on sale of old machine:

                   Market value                                      1,000

          Less total book value                                 5,000

          Loss on disposal                                        4,000

          Tax shield = 40% x 4,000                                                           (6,000)

          Incremental initial capital                                                            9,400

 

b)      Depreciation of new machine         =      12,000 - 2.000 /10 years      1,000

          Depreciation of old machine           =       5,000 - 0 / 10 yrs                 500

          Incremental depreciation                                                                     500

 

NB: The NBV of old machine after 5 years is of £5,000.  This NBV will be depreciated over the maintaining 10 years.

 

Determine operating cash flows:

Incremental sales         =                           11,000 - 10,000                             1,000

Savings in labor costs =                             5,000 - 7,000                                 2,000

Incremental EBDT                                                                                             3,000

Less incremental depreciation OR non-cash item                                            (500)

Incremental EBT                                                                                              2,500

Less tax @ 40%                                                                                              1,000

Incremental EAT                                                                                              1,500

Add back incremental depreciation                                                                  500

Annual cash flow                                                                                              2,000

Terminal cash flows at end of year 10 are equal to incremental salvage value.

New machine salvage value                                                           2,000

Less old machine salvage value                                                            0

                                                                                                         2,000

Compute the NPV @10 percent cost of capital:

P.V of cash flows = 2000 * 1-(1.1)-10 / 0.10 = 2,000*PVAF10% , 10 = 2,000 * 6.145

                                                                                                                              12,290

P.V of salvage value =2000 * 1 / (1.1)10 = 2,000*PVIF10%, 10 = 2,000 * 0.386

                                                                                                                               772

                                                                                                                          13,062

          Less incremental initial capital                                                                (9,400)

          Incremental N.P.V                                                                                     3,662

          Swap the old machine

Posted Date: 1/31/2013 1:33:54 AM | Location : United States







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