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Question:

A firm is currently using a machine which was purchased two years ago for $ 70,000 and has a
remaining useful life of 5 yea$

It is considering to replace the machine with a new one which will cost $ 1,40,000. The cost of
installation will amount to $ 10,000. The increase in working capital will be $ 20,000 The expected
cash inflows before depreciation and taxes for both the machines are as follows:

Year Existing Machine New Machine

1 $30, 000 $ 50,000

2 30,000 60,000

3 30,000 70,000

4 30,000 90,000

5 30,000 1,00,000

The firm use Straight Line Method of depreciation. The average tax on income as well as on capital
gain/loss is 40%.

Calculate the incremental cash flows assuming sale value of existing machine : (i) $ 80,000 (ii) $
60,000 (iii) $ 50,000 , and (iv) $ 30,000.

Solution:

Incremental Initial cash outflow:

Different Cases of Scrap Values

Cost of new machine $ 1,40,000 $ 1,40,000 $ 1,40,000 $ 1,40,000

+Installation Cost 10,000 10,000 10,000

10,000

+Additional Working Capital 20,000 20,000 20,000 20,000

-Scarp Value 80,000 60,000 50,000

30,000

90,000 1,10,000 1,20,000

1,40,000
Tax liability/saving 12,000 4,000 - -8,000

Cash outflow 1,02,000 1,14,000 1,20,000 1,32,000

Calculation of tax paid/saved :

Book value of old plant 50,000 50,000 50,000 50,000

-Scrap value 80,000 60,000 50,000 30,000

Profit/Loss 30,000 10,000 - (20,000)

Tax @ 40% on capital gain/loss 12,000 4,000 - -8,000

Subsequent Cash inflows (Annual) :

Year 1 Year 2 Year 3 Year 4 Year 5

Cash Inflows (before dep. and tax):

On New machine $ 50,000 $ 60,000 $ 70,000 $ 90,000 $ 1,00,00

On Old machine 30,000 30,000 30,000 30,000

30,000

Incremental Cash inflow 20,000 30,000 40,000 60,000

70,000

-Incremental depreciation 20,000 20,000 20,000 20,000

20,000

Profit before tax - 10,000 20,000 40,000

50,000

-Tax at 40% - 4,000 8,000 16,000

20,000

Profit after Tax - 6,000 12,000 24,000

30,000

Depreciation (added back) 20,000 20,000 20,000 20,000

20,000

Net cash inflow 20,000 26,000 32,000 44,000

50,000
The amount of incremental depreciation has been calculated as follows:

Depreciation on new machine = ($ 1,40,000 + $ 10,000 )/5

= $ 30,000.

Depreciation on old machine = $ 70,000/7

= $ 10,000.

Therefore, incremental depreciation = $ 20,000

Terminal cash flow: There will be a terminal cash flow of $ 20,000 at the end of 5th year in the
form of working capital released.