24 line basis down to 15000 over a period of 5 years Their initial cost was

24 line basis down to 15000 over a period of 5 years

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24 line basis down to $15,000 over a period of 5 years. Their initial cost was $65,000 and they were purchased three years ago. The new ovens will produce pre-tax labor cost savings of $18,000 per year and due to their increased capacity will increase sales and contribute an additional $20,000 before taxes to gross margin. There will be no change in fixed costs and other overhead. Due to increased sales, Schmidt will experience an increase in raw material inventory of $4,000 as well as accounts receivable of $2,500. Some of these increases will be offset by an increase in current liabilities of $3,000. Schmidt plans to operate the new ovens for four years. They can be depreciated according to the MACRS 5-year class schedule. Net working capital will be recoverable at book value. The new ovens will cost Schmidt $115,000 inclusive of shipping, handling, taxes and installation costs. They are projected to have a salvage value of $35,000 after four years. The old ovens can be sold in the market for $7,000 net of handling costs and sales commission. Schmidt has a 9% cost of capital and is in the 33% marginal tax bracket. Should the company replace its old ovens which can still be operated for another four years with minimum maintenance and repairs? They will be discarded at zero salvage value after four years and will not be depreciated in years 3 and 4. Computations: Table 1: Basic Information Additional sales margin contribution 20,000 per year Labor cost savings 18,000 per year NWC recovery 100% of book value Tax rate 33% Cost of capital 9% Table 2: Initial Capital Outlay Cost of new ovens 115,000 Change in NWC 3,500 Total capital outlay 118,500 1 Depreciable assets 115,000 2 1 Total capital outlay = 115,000 + 3,500 = 118,500. 2 Depreciable assets = 115,000. NWC is not depreciable. Table 3: MACRS Depreciation Schedule: 5-year Class Year 1 Year 2 Year 3 Year 4 Depreciation rate 20% 32% 19% 12% Depreciation - new 23,000 3 36,800 21,850 13,800 3 20% x Depreciable assets (from Table 2) = 0.20 x 115,000 = 23,000, and so on for the other years.
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Corporate Finance – Investing & Financing Decisions © 2005 finSage Inc. 25 Table 4: Project Cash Flows Cash flow item Year 0 Year 1 Year 2 Year 3 Year 4 Additional margin 20,000 20,000 20,000 20,000 Change in COGS -18,000 4 -18,000 -18,000 -18,000 Depreciation - old 10,000 5 10,000 0 0 Depreciation - new 23,000 6 36,800 21,850 13,800 Change in depreciation 13,000 7 26,800 21,850 13,800 Profit before tax (change) 25,000 8 11,200 16,150 24,200 Tax @ 33% 8,250 9 3,696 5,330 7,986 Net income 16,750 10 7,504 10,821 16,214 Add: Change in depreciation 13,000 26,800 21,850 13,800 Cash flow 29,750 11 34,304 32,671 30,014 NWC: Book value 3,500 3,500 3,500 3,500 Change in NWC 0 12 0 0 0 Optg. cash flow 29,750 13 34,304 32,671 30,014 Term. cash flow/asset sales 28,452 14 Initial outlay -102,260 15 Total cash flow -102,260 29,750 16 34,304 32,671 58,466 17 NPV @ 9% 20,553 18 4 Due to labor savings COGS will decline by 18,000. 5 Old depreciation is based on straight line: (Original cost – Salvage value) ÷ Economic life = (65,000 – 15,000) ÷ 5 = 10,000. Since three years have passed, the old oven will be depreciated for two more years only. 6 New depreciation is obtained from Table 3.
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