Use the following information to answer the following question(s).
A firm is trying to determine whether to replace an existing asset.The proposed asset has a purchase price of $50,000 and has installation costs of $3,000.The asset will be depreciated over its five-year useful life using the straight-line method.The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the useful life of the asset.Due to the increase in sales,the firm expects an increase in working capital during the asset's useful life of $1,500,and the firm expects to be able to sell the asset for $6,000 at the end of its useful life.The existing asset was originally purchased three years ago for $25,000,has a remaining useful life of five years,and is being depreciated using the straight-line method.The expected salvage value at the end of the asset's useful life (i.e. ,five years from now)is $5,000;however,the current sale price of the existing asset is $20,000,and its current book value is $15,625.The firm's marginal tax rate is 34 percent and its required rate of return is 12 percent.
-If the new machine is purchased,operating cash flow for years 1 through 5 will increase or decrease by how much?
A)Increase by $15,000
B)Decrease by $9,900
C)Increase by $12,142
D)Increase by $5,346

Question

Quizplus · Accepted Answer

To calculate the operating cash flow for years 1 through 5, we need to find the incremental cash flows of the new asset and subtract the incremental cash flows of the existing asset.

Incremental cash flows of the new asset:
Increase in sales revenue: $17,000 per year
Increase in non-depreciation expenses: $2,000 per year
Increase in working capital: $1,500
Salvage value: $6,000

The initial cash outflow for the new asset is the purchase price plus installation costs, which is $53,000 ($50,000 + $3,000).

Now we need to calculate the incremental cash flows for the existing asset.

Incremental cash flows of the existing asset:
Sale price: $20,000 (current market value)
Tax savings from depreciation: $1,563 per year ($15,625 book value ÷ 5 years × 34% tax rate)

The calculation for tax savings from depreciation is:
Depreciation per year = $25,000 ÷ 5 years = $5,000 per year
Tax savings from depreciation = Depreciation per year × Marginal tax rate

The incremental cash flow of the existing asset is the sale price minus the tax on the gain:
$20,000 – ($20,000 – $15,625) × 34% = $18,338

To find the operating cash flow for years 1 through 5, we subtract the incremental cash flows of the existing asset from the incremental cash flows of the new asset:
($17,000 + $2,000 – $1,500 + $6,000) – ($53,000 – $18,338) = $12,142 per year

Therefore, operating cash flow for years 1 through 5 will increase by $12,142 if the new machine is purchased. The answer is C.

Use the Following Information to Answer the Following Question(s)