# The History Of Inancial Management Accounting Essay

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Bug Busters of Antarctica, Inc. is considering replacing a machine with a new machine that has a four-year life. The purchase of this new machine has a cost of $700,000, shipping cost of $80,000, and an installation charge of $20,000. This machine will not require any additional working capital. The "old" project can be salvaged for $120,000 currently. The "old" machine has four years useful life remaining with a depreciation expense of $20,000 for each of those years and was originally purchased six years ago for $200,000. The "new" project will not generate additional revenues, but will decrease operating expenses by $290,000 for each year of the four-year project. For tax purposes, the equipment will be depreciated @ 30% using WDV method. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year for the "new" project is expected to be $50,000. Compute the following:

Net incremental cash flows for the project

Compute the NPV and IRR of the project for project acceptance at 10% hurdle

Given:

## New Machine

## Old Machine

Life: 4 years

Salvage Value: 120,000

Cost: 700,000

Remaining Life: 4 years

Shipping Cost: 80,000

Original Purchase Price: 200,000

Installation Charge: 20,000

Total Life: 10 years

Operating Expense Reduction: 290,000

Depreciation: 20,000

Depreciation @30% using WDV

Salvage Value: 50,000

Marginal Tax Rate: 40%

Total Cost of New Machine: 700,000+ 80,000+20,000 = 800,000

## Depreciation Schedule of Old and New Machine:

## Items

## Year 1

## Year 2

## Year 3

## Year 4

Old Machine

Book Value at beginning of year

80000

60000

40000

20000

Depreciation

20000

20000

20000

20000

Book Value at end of year

60000

40000

20000

0

New Machine

Book Value at beginning of year

800000

560000

392000

274400

Depreciation

240000

168000

117600

82320

Book Value at end of year

560000

392000

274400

192080

Incremental Depreciation

220000

148000

97600

62320

Replacement Cost: 800,000- 120,000 + (120,000-80,000)*(0.4) = 696,000

Tax Adjusted Salvage Value of New Machine at end of year 4: 50000 + (192080-50000)*(0.4) = 106832

## Net Incremental Cash Flows (All items are incremental items):

## Items

## Year 0

## Year 1

## Year 2

## Year 3

## Year 4

Operating Expense

290000

290000

290000

290000

Operating Income

290000

290000

290000

290000

Subtract Depreciation

220000

148000

97600

62320

EBIT

70000

142000

192400

227680

Subtract Tax (@40%)

28000

56800

76960

91072

Net Income

42000

85200

115440

136608

Add Back Depreciation

220000

148000

97600

62320

Subtract Replacement Cost

696,000

Add Tax Adjusted Salvage Of New Machine

106832

Cash Flows

-696,000

262,000

233,200

213,040

305,760

At 10% hurdle:

Using discount factor tables:

NPV = -696,000 + 262,000*0.9091 + 233,200*0.8264 + 213,040*0.7513 + 305,760*0.6830 = 103792

## IRR Calculations:

Average Cash Flow per Year: (262000+233200+213200+213040+305760)/4 = 253500

Estimate of payback period: 696000/253500 = 2.7456

From present factor annuity tables, 2.7456 for a period of 4 years corresponds to a rate of 18%

NPV (@18%) = -696,000 + 262,000*0.847 + 233,200*0.718 + 213,040*0.609 + 305,760*0.516 = -19135

NPV (@17%) = -696,000 + 262,000*0.855 + 233,200*0.731 + 213,040*0.624 + 305,760*0.534 = -5308

NPV (@16%) = -696,000 + 262,000*0.862 + 233,200*0.743 + 213,040*0.641 + 305,760*0.552 = 8450

IRR = 16 + {(17-16)/ (-5308-8450)}*(0-8450) = 16.61%

The IRR is approximately equal to 16.61%

## The NPV of the project is greater than zero and the IRR is greater than the hurdle rate. Hence, the company should replace the old machine with the new machine

Adam Smith is considering automating his pen factory with the purchase of a $475,000 machine. Shipping and installation would cost $5,000. Smith has calculated that automation would result in savings of $45,000 a year due to reduced scrap and $65,000 a year due to reduced labor costs. The machine has a useful life of 4 years and depreciable @ 30% WDV method. The estimated salvage value of the machine at the end of four years is $120,000. The old machine is fully depreciated, but has a salvage value today of $100,000. The firm's marginal tax rate is 34 percent. Compute the following:

Net incremental cash flows for the project

Compute the NPV and IRR of the project for project acceptance at 10% hurdle

Given:

## New Machine

## Old Machine

Life: 4 years

Salvage Value: 100,000

Cost: 475,000

Shipping & Installation: 5000

Savings due to reduced crap: 45000

Savings due to reduced labor cost: 65000

Depreciation @30% using WDV

Salvage Value: 120,000

Marginal Tax Rate: 34%

Total Cost of new machine: 475000+5000 = 480,000

Depreciation Schedule of New Machine:

## Items

## Year 1

## Year 2

## Year 3

## Year 4

New Machine

Book Value at beginning of year

480000

336000

235200

164640

Depreciation

144000

100800

70560

49392

Book Value at end of year

336000

235200

164640

115248

Assuming that the old machine has been fully depreciated to its salvage value and there are no capital gains or losses while replacing it.

Replacement Cost: 480,000-100,000 = 380,000

Tax Adjusted Salvage Value of New Machine at end of year 4: 115248 - (120000-115248)*(0.34) = 113632

## Net Incremental Cash Flows (All items are incremental items):

## Items

## Year 0

## Year 1

## Year 2

## Year 3

## Year 4

Total Savings

110000

110000

110000

110000

Operating Income

110000

110000

110000

110000

Subtract Depreciation

144000

100800

70560

49392

EBIT

-34000

9200

39440

60608

Subtract Tax (@34%)

-11560

3128

13409.6

20606.72

Net Income

-22440

6072

26030.4

40001.28

Add Back Depreciation

144000

100800

70560

49392

Subtract Replacement Cost

380,000

Add Tax Adjusted Salvage Of New Machine

113632

Cash Flows

-380,000

121,560

106,872

96,590

203,025

At 10% hurdle:

Using discount factor tables:

NPV = -380,000 + 121,560*0.9091 + 106,872*0.8264 + 96,590*0.7513 + 203,025*0.6830 = 30063

## IRR Calculations:

Average Cash Flow per Year: (121,560 + 106,872 + 96,590 + 203,025)/4 = 132012

Estimate of payback period: 380000/132012 = 2.8785

From present factor annuity tables, 2.8785 for a period of 4 years corresponds to a rate of 14%

NPV (@14%) = -380,000 + 121,560*0.877 + 106,872*0.769 + 96,590*0.675 + 203,025*0.592 = -5818

NPV (@13%) = -380,000 + 121,560*0.885 + 106,872*0.783 + 96,590*0.693 + 203,025*0.613 = 2653

IRR = 13 + {(14-13)/ (-5818-2653)}*(0-2653) = 13.31%

The IRR is approximately equal to 13.31%

## The NPV of the project is greater than zero and the IRR is greater than the hurdle rate. Hence, Adam Smith should automate his factory

Wee Ltd. plan on purchasing a new assembly machine for $ 25,000. It will cost $ 2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine @ 40% over 5 years under the WDV method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%. Assume that an existing machine can be sold for $ 6,000. Compute the following:

Net incremental cash flows for the project

Compute the NPV and IRR of the project for project acceptance at 10% hurdle

Given:

## New Machine

## Old Machine

Life: 5 years

Salvage Value: 6,000

Cost: 25,000

Installation Charge: 2,000

Increase in Working Capital: 1,000

Operating Expense Reduction: 7,000

Maintenance Savings: 500

Technical Support: 750

Depreciation @40% using WDV

Salvage Value: 5,000

Marginal Tax Rate: 35%

Total Cost of New Machine: 25,000 +2,000 = 27,000

Depreciation Schedule of New Machine:

## Items

## Year 1

## Year 2

## Year 3

## Year 4

## Year 5

New Machine

Book Value at beginning of year

27000

16200

9720

5832

3499

Depreciation

10800

6480

3888

2333

1400

Book Value at end of year

16200

9720

5832

3499

2100

Assuming that the old machine has been fully depreciated to its salvage value and there are no capital gains or losses while replacing it.

Replacement Cost: 27,000-6,000 = 21,000

Tax Adjusted Salvage Value of New Machine at end of year 4: 5000 - (5000-2100)*(0.35) = 3985

## Net Incremental Cash Flows (All items are incremental items):

## Items

## Year 0

## Year 1

## Year 2

## Year 3

## Year 4

## Year 5

Total Savings

7500

7500

7500

7500

7500

Technical Support Expense

750

750

750

750

750

Operating Income

6750

6750

6750

6750

6750

Subtarct Depreciation

10800

6480

3888

2333

1400

EBIT

-4050

270

2862

4417

5350

Subtract Tax (@35%)

-1418

95

1002

1546

1873

Net Income

-2633

176

1860

2871

3478

Add Back Depriciation

10800

6480

3888

2333

1400

Subtract Replacement Cost

21000

Subtract Increase In WC

1000

Add Release of WC

1000

Add Tax Adjusted Salvage Of New Machine

3985

Cash Flows

-22000

8168

6656

5748

5204

8862

At 10% hurdle:

Using discount factor tables:

NPV = -22000 + 8168*0.9091 + 6656*0.8264 + 5748*0.7513 + 5204*0.6830 + 8862*0.621 = 4302

## IRR Calculations:

Average Cash Flow per Year: (8168 + 6656 + 5748 + 5204 + 8862)/5 = 6928

Estimate of payback period: 22000/6928 = 3.1755

From present factor annuity tables, 3.1755 for a period of 5 years corresponds to a rate of 17%

NPV (@17%) = -22000 + 8168*0.855 + 6656*0.731 + 5748*0.624 + 5204*0.534 + 8862*0.456 = 256

NPV (@18%) = -22000 + 8168*0.847 + 6656*0.718 + 5748*0.609 + 5204*0.516 + 8862*0.437 = -244

IRR = 17 + {(18-17)/ (-244-256)}*(0-256) = 17.51%

The IRR is approximately equal to 17.51%

## The NPV of the project is greater than zero and the IRR is greater than the hurdle rate. Hence, Wee Ltd. Smith should purchase the new assembly line

The Smith Company is a beauty products company that is considering a new hair growth product. This new product would encourage hair growth for persons with thinning hair. The new product is expected to generate sales of $500,000 per year and would cost $300,000 to produce each year. It is expected that the patent on the new product would prevent competition from entering the market for at least seven years. Smith Company spent $1,000,000 developing the new product over the past four years. The equipment to produce the new product would cost $1,500,000 and would be depreciated for tax purposes as a 35% WDV. Smith's management estimates that the equipment could be sold after seven years for $400,000. The marginal tax rate for Smith Company is 40%. Compute the following:

Net incremental cash flows for the project

Compute the NPV and IRR of the project for project acceptance at 10% hurdle

Given:

## New Machine

Life: 7 years

Cost of Equipment: 1,500,000

Sales: 500,000

Operating Expense: 300,000

Depreciation @35% using WDV

Salvage Value: 400,000

Marginal Tax Rate: 40%

Depreciation Schedule of Equipment:

## Items

## Year 1

## Year 2

## Year 3

## Year 4

## Year 5

## Year 6

## Year 7

New Machine

Book Value at beginning of year

1500000

975000

633750

411938

267759

174044

113128

Depreciation

525000

341250

221813

144178

93716

60915

39595

Book Value at end of year

975000

633750

411938

267759

174044

113128

73533

Tax Adjusted Salvage Value of New Machine at end of year 4: 400,000 - (400,000-73,533)*(0.4) = 269,413

## Net Incremental Cash Flows (All items are incremental items):

## Items

## Year 0

## Year 1

## Year 2

## Year 3

## Year 4

## Year 5

## Year 6

## Year 7

Sales

500000

500000

500000

500000

500000

500000

500000

Cost of production

300000

300000

300000

300000

300000

300000

300000

Operating Income

200000

200000

200000

200000

200000

200000

200000

Subtract Depreciation

525000

341250

221813

144178

93716

60915

39595

EBIT

-325000

-141250

-21813

55822

106284

139085

160405

Subtract Tax (@40%)

-130000

-56500

-8725

22329

42514

55634

64162

Net Income

-195000

-84750

-13088

33493

63771

83451

96243

Add Back Depreciation

525000

341250

221813

144178

93716

60915

39595

Subtract Replacement Cost

1500000

Add Tax Adjusted Salvage Of New Machine

269,413

Cash Flows

-1500000

330000

256500

208725

177671

157486

144366

405251

At 10% hurdle:

Using discount factor tables:

NPV = -1,500,000 + 330,000*0.9091 +256,500*0.8264 + 208,725*0.7513 + 177,671*0.6830 + 157,486*0.621 + 144,366*0.564 + 405,251*0.513= -322,746

## IRR Calculations:

Average Cash Flow per Year: (330,000 +256,500 + 208,725 + 177,671 + 157,486 + 144,366 + 405,251)/7 = 240,000

Estimate of payback period: 1,500,000/240,000 = 6.25

From present factor annuity tables, 6.25 for a period of 7 years corresponds to a rate of 2%

NPV (@2%) = -1,500,000 + 330,000*0.980 +256,500*0.961 + 208,725*0.942 + 177,671*0.924 + 157,486*0.906 + 144,366*0.888 + 405,251*0.871 = 54,256

NPV (@3%) = -1,500,000 + 330,000*0.971 +256,500*0.943 + 208,725*0.915 + 177,671*0.888 + 157,486*0.863 + 144,366*0.837 + 405,251*0.813 = -2721

IRR = 2 + {(3-2)/ (-2721-54256)}*(0-54265) = 2.95%

The IRR is approximately equal to 2.95%