High School

Yellowstone Co. is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The existing grinder was purchased 3 years ago at an installed cost of $80,000; it was being depreciated under MACRS using a 5-year recovery period. The existing grinder is expected to have a usable life of 5 more years. The new grinder costs $125,000 and requires $5,000 in installation costs; it has a 5-year usable life and would be depreciated under MACRS using a 5-year recovery period.

Yellowstone can currently sell the existing grinder for $90,000 without incurring any removal or cleanup costs. To support the increased business resulting from the purchase of the new grinder, accounts receivable would increase by $50,000, inventories by $35,000, and accounts payable by $47,000. At the end of 5 years, the existing grinder would have a market value of $10,000; the new grinder would be sold to net $35,000 after removal and cleanup costs and before taxes. The firm is subject to a 40% tax rate. The estimated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the following table.

a. Calculate the initial investment associated with the replacement of the existing grinder by the new one.
b. Determine the incremental operating cash inflows associated with the proposed grinder replacement.
c. Determine the terminal cash flow expected at the end of year 5 from the proposed grinder replacement.
d. Depict on a timeline the relevant cash flows associated with the proposed grinder replacement decision.
e. Calculate the Payback Period, Net Present Value, and Internal Rate of Return if the cost of capital is 15%.
f. What is the conclusion of this proposed replacement decision, go or no-go, if the management wants to pay back in 4.5 years?

Answer :

a. The initial investment associated with the replacement of the existing grinder by the new one needs to be calculated.

b. The incremental operating cash inflows associated with the proposed grinder replacement must be determined.

c. The terminal cash flow expected at the end of year 5 from the proposed grinder replacement should be calculated.

d. A timeline depicting the relevant cash flows associated with the proposed grinder replacement decision needs to be created.

e. The Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR) should be calculated with a cost of capital of 15%.

f. The conclusion of the proposed replacement decision, either "go" or "no-go," needs to be determined if the management wants to pay back in 4.5 years.

a. To calculate the initial investment, we need to consider the cost of the new grinder ($125,000), installation costs ($5,000), and the net cash inflow from selling the existing grinder ($90,000 - removal or cleanup costs). The initial investment is the sum of these amounts.

b. The incremental operating cash inflows are the changes in accounts receivable, inventories, and accounts payable over the 5-year period. We add the changes in accounts receivable and inventories, and subtract the change in accounts payable to calculate the incremental operating cash inflows.

c. The terminal cash flow expected at the end of year 5 is the market value of the existing grinder ($10,000) plus the net cash inflow from selling the new grinder ($35,000 - removal and cleanup costs) after taxes.

d. The timeline should show the initial investment as a cash outflow, the incremental operating cash inflows over the 5 years, and the terminal cash flow at the end of year 5.

e. The Payback Period is the time it takes for the initial investment to be recovered. NPV is calculated by discounting the cash inflows and outflows at the cost of capital and summing them. IRR is the discount rate that makes the NPV equal to zero. These calculations can be done using the given cash flows and the cost of capital of 15%.

f. To determine the conclusion of the proposed replacement decision, we compare the Payback Period to the desired payback period of 4.5 years. If the Payback Period is less than or equal to 4.5 years, the decision is to proceed with the replacement; otherwise, it is a no-go.

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