Kandy Corporation is considering a replacement investment....

Kandy Corporation is considering a replacement investment. The machine currently in use was originally purchased two years ago for $$\$ 65,000$$. Tax-allowable depreciation is $$\$ 13,000$$ per year for five years. The current market value of this machine is $$\$ 23,000$$. The new machine being considered would cost $$\$ 140,000$$, and require $$\$ 4,000$$ shipping costs and $$\$ 2,000$$ installation costs. The economic life of the machine is estimated as three years. Tax-allowable depreciation is $$\$ 70,000$$ per year for the first two years. If the new machine is acquired, the investments in accounts receivable is expected to increase by $$\$ 9,000$$, the inventory by $$\$ 13,000$$, and accounts payable by $$\$ 15,000$$. The before-tax net operating cash flow is estimated as $$\$ 120,000$$ per year for the next three years with the old machine and $$\$ 143,000$$ per year for the next three years with the new machine. The expected resale value of the old and new machines in three years' time would be $$\$ 4,000$$ and $$\$ 6,600$$, respectively. The corporate tax rate is $30 \%$. (a) Calculate the initial investment associated with the proposed replacement decision. (b) Calculate the incremental operating cash flows of the proposed replacement decision. (c) Calculate the terminal cash flows associated with the proposed replacement decision. (d) Compute the NPV of the replacement project assuming a discount rate of $6 \%$ per annum. (e) What is the proposed investment's IRR? (f) Use the computed IRR and NPV results and discuss the project accept/reject decision.

Kandy Corporation is considering a replacement investment. The machine currently in use was originally purchased two years ago for $$\$ 65,000$$. Tax-allowable depreciation is $$\$ 13,000$$ per year for five years. The current market value of this machine is $$\$ 23,000$$.
The new machine being considered would cost $$\$ 140,000$$, and require $$\$ 4,000$$ shipping costs and $$\$ 2,000$$ installation costs. The economic life of the machine is estimated as three years. Tax-allowable depreciation is $$\$ 70,000$$ per year for the first two years. If the new machine is acquired, the investments in accounts receivable is expected to increase by $$\$ 9,000$$, the inventory by $$\$ 13,000$$, and accounts payable by $$\$ 15,000$$. The before-tax net operating cash flow is estimated as $$\$ 120,000$$ per year for the next three years with the old machine and $$\$ 143,000$$ per year for the next three years with the new machine. The expected resale value of the old and new machines in three years' time would be $$\$ 4,000$$ and $$\$ 6,600$$, respectively. The corporate tax rate is $30 \%$.
(a) Calculate the initial investment associated with the proposed replacement decision.
(b) Calculate the incremental operating cash flows of the proposed replacement decision.
(c) Calculate the terminal cash flows associated with the proposed replacement decision.
(d) Compute the NPV of the replacement project assuming a discount rate of $6 \%$ per annum.
(e) What is the proposed investment's IRR?
(f) Use the computed IRR and NPV results and discuss the project accept/reject decision.

Key Concepts

Internal Rate of Return (IRR)

The IRR is the interest rate at which the net present value of all the cash flows from a project equals zero. It represents the project’s break-even cost of capital and provides a basis for comparing the efficiency of various investments. A project is generally considered acceptable if its IRR exceeds the required rate of return; however, the IRR must be interpreted in context with other factors like project scale and timing of cash flows.

Working Capital Adjustments

Working capital adjustments involve changes in short?term assets and liabilities resulting from investment decisions. In capital projects, investments in accounts receivable, inventory, and accounts payable need to be accounted for, as they affect the net cash flow both at the start and at the end of the project. Proper treatment of these adjustments is essential for an accurate portrayal of a project’s financial impact.

Net Present Value (NPV) Analysis

NPV analysis discounts all future cash flows, both inflows and outflows, back to present value terms using a chosen discount rate. This method helps determine whether the investment will produce a net gain or loss in today's dollars. A positive NPV indicates that the projected earnings, in present value terms, exceed the anticipated costs, typically justifying acceptance of the project.

Terminal Cash Flow Analysis

Terminal cash flow analysis involves determining the net cash flow at the end of a project’s life. This includes the salvage value of assets, costs associated with disposing of assets, and the recovery of previously invested working capital. This final cash flow is critical because it can significantly affect the overall profitability of the project and must be accurately estimated when performing a comprehensive capital budgeting analysis.

Depreciation and Tax Shield

Depreciation is the allocation of the cost of a tangible asset over its useful life for accounting and tax purposes. A key related concept is the tax shield, which is the reduction in taxes due to the depreciation expense that reduces taxable income. Correctly accounting for depreciation is crucial in capital budgeting as it impacts the net operating cash flows and ultimately the financial appraisal of the investment.

Incremental Operating Cash Flows

Incremental operating cash flows refer to the net changes in cash flows that occur as a result of choosing one alternative over another. In replacement decisions, these are computed as the differences between the operating incomes generated by the new investment versus the existing asset. The concept emphasizes that only the additional or reduced cash flows resulting from the new project are relevant for evaluating its financial viability.

Initial Investment Analysis

This concept involves calculating all the upfront costs and cash flows required to begin a project. It includes capital expenditure items such as purchase price, installation, and transportation costs, as well as adjustments for changes in net working capital. If there is any disposal or resale of an existing asset, its market value or salvage value is subtracted from the investment. This analysis sets the stage for evaluating whether the project makes financial sense from the very start.

Please give Ace some feedback