Determining relevant cash flows A machine currently in use was originally purchased 2 years ago for…

| January 31, 2015

Determining relevant cash flows A machine currently in use was originally purchased 2 years ago for $40,000. The machine is being depreciated under MACRS using a 5-year recovery period; it has 3 years of usable life remaining. The current machine can be sold today to net $42,000 after removal and cleanup costs. A new machine, using a 3-year MACRS recovery period, can be purchased at a price of $140,000. It requires $10,000 to install and has a 3-year usable life. 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. Earnings before depreciation, interest, and taxes are expected to be $70,000 for each of the next 3 years with the old machine and to be $120,000 in the first year and $130,000 in the second and third years with the new machine. At the end of 3 years, the market value of the old machine will equal zero, but the new machine could be sold to net $35,000 before taxes. The firm is subject to a 40% tax rate. (Table 4.2 on page 117 contains the applicable MACRS depreciation percentages.)

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 that it is terminated at the end of year 3.

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