PArT 3: CAPITAL BUDGETING
c Costs of ramping up production of the new device.
d Increases in receivables and inventory that will occur as production increases.P10-10 Big Apple Pizza is considering replacing an existing oven with a new, more sophisticated oven.
The old oven was purchased three years ago at a cost of $20,000, and this amount was being
depreciated under the diminishing value method using a five-year recovery period. The oven
has five years of useable life remaining. The new oven being considered costs $30,500, requires
$1,500 in installation costs, and would be depreciated under the diminishing value method using
a five-year recovery period. The old oven can currently be sold for $22,000, without incurring any
removal or clean-up costs. The company pays taxes at a rate of 30% on both ordinary income
and capital gains. The revenues and expenses (excluding depreciation) associated with the new
and the old machines for the next five years are given in the following table.New oven Old oven
Year Revenue Expenses (excluding
depreciation)Revenue Expenses (excluding
depreciation)
1 $300,000 $288,000 $270,000 $264,000
2 300,000 288,000 270,000 264,000
3 300,000 288,000 270,000 264,000
4 300,000 288,000 270,000 264,000
5 300,000 288,000 270,000 264,000a Calculate the initial cash outflow associated with replacement of the old oven with a new one.
b Determine the incremental cash flows associated with the proposed replacement. Be sure to
consider the depreciation in year 6.
c Depict on a time line the incremental cash flows found in parts (a) and (b) that are associated
with the proposed replacement decision.
P10-11 Speedy Auto Wash is contemplating the purchase of a new high-speed washer to replace
the existing washer. The existing washer was purchased two years ago at an installed cost
of $120,000; it was being depreciated under the diminishing value method using a five-year
recovery period. The existing washer is expected to have a useable life of five more years. The
new washer costs $210,000 and requires $10,000 in installation costs; it has a five-year useable life
and would be depreciated under the diminishing value method using a five-year recovery period.
The existing washer can currently be sold for $140,000, without incurring any removal or clean-up
costs. To support the increased business resulting from purchase of the new washer, accounts
receivable would increase by $80,000, inventories by $60,000 and accounts payable by $116,000.
At the end of five years, the existing washer is expected to have a market value of zero; the new
washer would be sold to net $58,000 after removal and clean-up costs, and before taxes. The
company pays taxes at a rate of 30% on both ordinary income and capital gains. The estimated
profits before depreciation and taxes over the five years for both the new and the existing washer
are shown in the following table.Profits before depreciation and taxes
Year New washer Existing washer
1 $86,000 $52,000
2 86,000 48,000
3 86,000 44,000
4 86,000 40,000
5 86,000 36,000