# replacement project terminal year

Atkinson is considering replacing a bottle blow molding machine. This machine was purchased for \$50,000 3 years ago and is being depreciated for tax purposes over 5 years to a zero salvage value using straight-line depreciation. The firm has 2 years of depreciation remaining on the old machine. If Atkinson decides to make the replacement, the old machine can be sold today for \$10,000. The new machine will cost the firm \$100,000. According to Ralston’s projections, the new machine will increase revenue by \$40,000 per year for 3 years but will also increase costs by \$5,000 per year. The machine will be depreciated over a modified accelerated cost recovery system (MACRS) 3-year class life. At the end of year 3, the equipment will be sold for \$20,000. The firm’s tax rate is 35%. The total cash flow from the bottle blow molding machine in year 3 is closest to: A) \$28,000. B) \$43,450. C) \$48,000. Your answer: B was correct! CF3 = OCF3 + terminal CF OCF3 = (40,000 – 5,000)(1 - .35) + [((.15)(100,000) - 0)(.35)] = \$28,000 ------------------- why is it [((.15)(100,000) - 0)(.35)] rather than [((.15)(100,000) - 10,000)(.35)]

1. did you mean 20000 instead of 10000?

no, because we are taking the change in depreciation tax shield since this is a replacement project. the annual depreciation is 50k/5 = 10k. the change in depreciation tax shield = (new MACRS dep - old SL dep)(T) on page 20 of schweser, it is explained in the example. i just want to double check with the forum because Qbank has occasional errors.

Should be 10000. This inconsistency fcuks me up in exam. I lost 3 points in BSAS because of stupid mistakes in finding NPV

old machine had only 2 years more - at which point it would be fully depreciated. so 0 due to old machine depreciation.

cpk123 Wrote: ------------------------------------------------------- > old machine had only 2 years more - at which point > it would be fully depreciated. so 0 due to old > machine depreciation. Agreed. Didn’t read the full question. Machine had 2 years life left and should not be counted in CF3. Good question.

If its a replacement, then doesnt the old machine get sold in Year 0? So the 2 remaining yrs of depreciation is a distractor, because the depreciation from the old machine shouldnt count in any yrs cash flow.

bobsters Wrote: ------------------------------------------------------- > If its a replacement, then doesnt the old machine > get sold in Year 0? > > So the 2 remaining yrs of depreciation is a > distractor, because the depreciation from the old > machine shouldnt count in any yrs cash flow. For tax purpose you still count that years depreciation

I see, btw how do you work out the return of NWC in this example? I get this: operating CF3 + sale + return of NWC (40-5-15)*0.65+15 + 20-0.35*(20-0) + ??? = 41 + ??

This is from Schweser: 40,000 – 5,000)(1 - .35) + [((.15)(100,000) - 0)(.35)] = \$28,000 So instead of zero, you deduct that year’s dep i.e. 10K What is that 15% come from? Is the question missing something?

15% the MACRS % for that year.

"So instead of zero, you deduct that year’s dep i.e. 10K " that’s what i said in the first place. still trying to rationalize the 0, but i think its wrong

PD, Read this: “The firm has 2 years of depreciation remaining on the old machine” They are asking you to calculate cash flow for year 3 which means you have already deducted for those 2 years and not nothing is left to deduct from that machine.

what page is this on? also how would you calculate the terminal CF. I dont understand where this .15 comes from - are we suppose to remember the MACRS % or is this given? CF3 = OCF3 + terminal CF OCF3 = (40,000 – 5,000)(1 - .35) + [((.15)(100,000) - 0)(.35)] = \$28,000

it should be given.

ok. got it. the depreciable basis for the old machine was 20k, not the purchase price of 50k since we are used that machine for 3 years… so it was 10k in y1, 10k in y2, 0 thereafter… thanks

50,000 3 years ago and now when they are selling book value is 20. In new project, you deduct that 20k in next 2 years.

I understand the OCF3 = 28000, but I still don’t understand how you go from 28000 to the answer of 43450.

The total cash flow for the terminal year is equal to the operating cash flow plus the non-operating (or terminating) cash flow. The operating cash flow equals: CF3 = (revenue − cost)3 × (1 − tax rate) + net depreciation3 × (tax rate) ((40,000 – 5,000) × 0.65) + [((0.15 × 100,000) − 0) × 0.35)] = \$28,000 The year 3 non-operating cash flow equals: Market or salvage value plus/minus tax consequences of selling it. The new machine will be sold for \$20,000. The book value is: \$100,000 × 0.07 = \$7,000 \$20,000 – \$7,000 = \$13,000 The firm will pay taxes on the gain of: 13,000 × 0.35 = \$4,550 Total terminal year cash flow = \$28,000 + \$20,000 – \$4,550 = \$43,450 Note: Once we have the project’s estimated cash flows, the next step in the process would be to calculate the net present value and internal rate of return for the project. (Study Session 8, LOS 28.a)

Ah thanks! Think I was close, what I tripped up on was how do you know the book value at the end is 100,000*0.07=7000? Is this from the MARCS tables too?