Principles of Managerial Finance

390 PART 3 Long-Term Investment Decisions

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a. Calculate the initial investment associated with the replacement of the exist-

ing grinder by the new one.

b. Determine the incremental operating cash inflows associated with the pro-

posed grinder replacement. (Note:Be sure to consider the depreciation in

year 6.)

c. Determine the terminal cash flow expected at the end of year 5 from the pro-

posed grinder replacement.

d. Depict on a time line the relevant cash flows associated with the proposed

grinder replacement decision.

8–25 Integrative—Determining relevant cash flows Atlantic Drydock is considering

replacing an existing hoist with one of two newer, more efficient pieces of equip-

ment. The existing hoist is 3 years old, cost $32,000, and is being depreciated

under MACRS using a 5-year recovery period. Although the existing hoist has

only 3 years (years 4, 5, and 6) of depreciation remaining under MACRS, it has

a remaining usable life of 5 years. Hoist A, one of the two possible replacement

hoists, costs $40,000 to purchase and $8,000 to install. It has a 5-year usable life

and will be depreciated under MACRS using a 5-year recovery period. The other

hoist, B, costs $54,000 to purchase and $6,000 to install. It also has a 5-year

usable life and will be depreciated under MACRS using a 5-year recovery period.

Increased investments in net working capital will accompany the decision to

acquire hoist A or hoist B. Purchase of hoist A would result in a $4,000 increase

in net working capital; hoist B would result in a $6,000 increase in net working

capital. The projected profits before depreciation and taxeswith each alternative

hoist and the existing hoist are given in the following table.

The existing hoist can currently be sold for $18,000 and will not incur any

removal or cleanup costs. At the end of 5 years, the existing hoist can be sold to

net $1,000 before taxes. Hoists A and B can be sold to net $12,000 and $20,000

before taxes, respectively, at the end of the 5-year period. The firm is subject to a

40% tax rate on both ordinary income and capital gains. (Table 3.2 on page 100

contains the applicable MACRS depreciation percentages.)

a. Calculate the initial investment associated with each alternative.

b. Calculate the incremental operating cash inflows associated with each alter-

native. (Note:Be sure to consider the depreciation in year 6.)

c. Calculate the terminal cash flow at the end of year 5 associated with each

alternative.

d. Depict on a time line the relevant cash flows associated with each alternative.

Profits before

depreciation and taxes

Year With hoist A With hoist B With existing hoist

1 $21,000 $22,000 $14,000

2 21,000 24,000 14,000

3 21,000 26,000 14,000

4 21,000 26,000 14,000

5 21,000 26,000 14,000