B6. (Cash flows and NPV for a replacement decision) Andrew Thompson Interests (ATI) is
using a mechanical switching system that it bought five years ago for $400,000. This
mechanical system is being depreciated straight line to an estimated salvage value of zero
over a 10-year life. Thus, the annual depreciation charge is $40,000 and current book value
is $200,000. At the end of its life, the actual salvage value is expected to be $25,000. If ATI
sold this equipment today, it would fetch $100,000.
ATI is evaluating a new digital switching system that will cost $500,000. The digital
system is depreciated straight line to a zero salvage value over a five-year life. At the end of
the five years, ATI expects to sell the system for $150,000. The new digital system should
have a favorable impact on operating cash flows, increasing revenues by $100,000 annually
and decreasing cash operating expenses by $50,000 annually. The new equipment has no
effect on the investment in working capital.
ATI is in the 40% tax bracket and has a 12% cost of capital. Consider each of the following
questions assuming that ATI sells the old mechanical switching system and replaces
it with the new digital system.
a. What is the net investment?
b. What is the after-tax net operating cash flow for each of the five years?
c. What is the after-tax salvage value?
d. What is the NPV of this investment?
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