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January 4, 2018
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January 4, 2018

Calculate the incremental operating cash flows that is expected from the purchase of the new drill.

La Familia Company limited is considering the purchase a high speed drill to replace the old one that they currently have.

The old drill was purchase 3 years ago at an installed cost of $500,000 and is estimated to have a usable life of 5 years.

The new drill is expected to cost $850,000 with $20,000 to be spent on installation and also has a 5 year usable life.

La Familia can sell the old drill at $60,000 inclusive of removal cost.

The purchase of this new drill will result in increase business and impact on the following:

  • Accounts Receivable increase by $55,000
  • Inventories by $25,000
  • Accounts payable by $42,000

At the end of the 5 years the new drill will have a residual value of $50,000 and should be sold for that amount.

La Familia funds it assets as follows:

Long term Bonds 25%

Preferred stock25%

Common stock50%

The interest on the bonds is 8%. The preferred stock pays dividends of 10%. The risk free rate is 4%, the beta on La Familia’s stock is 1.2 and the market risk premium is 8%.

La Familia tax rate is 25%

Straight line method of depreciation applies.

Earnings before depreciation and taxes are as follows:

Year

New Drill

Old Drill

1

$125,000

$35,000

2

$250,000

$30,000

3

$275,000

$28,000

4

$275,000

$22,000

5

$175,000

$10,000

  1. Calculate the initial Investment for the replacement of the old drill with the new drill.
  2. Calculate the incremental operating cash flows that is expected from the purchase of the new drill.
  3. What is the terminal cash flow at the end of year 5 due to the replacement of the old drill with the new one.
  4. Should the new drill be purchased based on NPV analysis and IRR?
  5. What other factors need to be consider before the decision to replace the old machine is made.
 

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