Making an investment decision

[Keebs]

Hello. I am hoping someone can help guide me through the problem below. I have tried working out the first part of the qusetion (for the new lathe), ut I dont know what do with the year 6 depreciation costs when the life of the lathe is only 5 years. Also, I am stuck on how to do the analysis for the second part (old lathe) and which criteria I shoudl use to determine which investment decision is best.

PROBLEM:

Strong Tool Company has been considering purchasing a new lathe as a replacement for a fully depreciated lathe that can last 5 more years. The new lathe is expected to have a 5-year life and depreciation charges of $2,000 in year 1; $3,200 in year 2; $1,900 in year 3; $1,200 in both year 4 and year 5; and $500 in year 6. The firm estimates the revenues and expenses (excluding depreciation and interest for the new and old lathes to be as show in the table below. The firm is subject to a 40% tax rate. The price of the new lath is $10,000 and the cost of capital is 10%. Should the new lathe be purchased? Year New lathe Old lathe Revenue Expenses (excl. depr. and int.) Revenue Expenses (excl. depr. and int.) 1 $40,000 $30,000 $35,000 $25,000 2 $41,000 $30,000 $35,000 $25,000 3 $42,000 $30,000 $35,000 $25,000 4 $43,000 $30,000 $35,000 $25,000 5 $44,000 $30,000 $35,000 $25,000 MY WORK: BTCF = before tax cash flow New Lathe Year Revenue Costs BTCF Taxable Income Tax Net Income 1 $40,000 $30,000 10,000.00 $ 9,600.00 $3,840.00 $ 5,760.00 2 $41,000 $30,000 11,000.00 $ 10,360.00 $4,144.00 $ 6,216.00 3 $42,000 $30,000 12,000.00 $ 11,620.00 $4,648.00 $ 6,972.00 4 $43,000 $30,000 13,000.00 $ 12,760.00 $5,104.00 $ 7,656.00 5 $44,000 $30,000 $ 14,000.00 $ 13,760.00 $5,504.00 $ 8,256.00 PW $15,967.20 FW $25,715.33 AW $4,212.11

 

[Tallulah]

Jeff,

I calculated taxable income by subtracting BTCF by the depreciation costs divided by the total number of periods. So, BTCF- (depreciation cost for year n/total number of periods).

For annual worth, I just used the exel PMT function =pmt(%, n, -PW,,)

I dont know how to calculate some of the items you listed below. The class that I am in is a finance class, but it is geared for engineering and science managers that just need to understand the basics of finance and accounting so we havent gotten that in depth with how to do these types of analyses. That is why I am struggling with this questions because I am lost on how to even approach it really.

 

[Tallulah]

Hi Jeff:

Okay, so I think I get it for the first part. Everything is very straight forward. Except, how did you calculate Cash from Operations after tax? Did you add Net income and depreciation? Could you explain why? Additionally, to do my PW analysis, woudl I use Cumulate Present Value to calculate?

Also, for part b, they did not provide any depreciation costs, so would I just ignore this criteria for the analysis? Or would I have to somehow calculate this? There is no salvage value, at least I assume there is none.

 

[Tallulah]

Thank you soo much for the explanation. This is a very difficult concept to understand when you are pretty much learning on your own and I think I understand now! Well, in economic terms as you explained depreciation would be zero, but in reality there is still a value attached to it. Am I getting this right? If so, I have no clue how to calculate it without pretty much guessing using the Excel SOLVER function, which I dont really know hwo to use. I decided to get further clairification from my professor and he said the value would be zero so I guess I dont need to worry about that. However, I dont know how to calculate PW without the initial cost of the old lathe. Is there another way to compare alternatives that I am missing here? Here is my chart for part b.

Year	Revenue	Cash Expense	Cash from Operations before Taxes	Depreciation	Taxable Income	Tax Expense at 40%	Net Income	Cash from Operations after tax (net cash flow)	PV of Net Cash Flow for year	PV of net cash flow for prior years	Cumulative PV
1	35000	25000	10000	0	10000	4000	6000	6000	5455
2	35000	25000	10000	0	10000	4000	6000	6000	4959	27500	32459
3	35000	25000	10000	0	10000	4000	6000	6000	4508	30250	34758
4	35000	25000	10000	0	10000	4000	6000	6000	4098	33275	37373
5	35000	25000	10000	0	10000	4000	6000	6000	3726	36603	40328

 

[Tallulah]

I calculated net cash flows for previous years for year 1 by multiplying cash expenses from year 0 by (1+0.10)^0. Did I not do this correctly?

Here are my tables.

New Lathe
	Year	Revenue	Cash Expense	Cash from Operations before Taxes	Depreciation	Taxable Income	Tax Expense at 40%	Net Income	Cash from Operations after tax (net cash flow)	PV of Net Cash Flow for year	PV of net cash flow for prior years	Cumulative PV
	0		-10000
	1	$40,000	$30,000	10000	2000	8000	3200	4800	6800	6182	-10000	-3818
	2	$41,000	$30,000	11000	3200	7800	3120	4680	7880	6512	11000	17512
	3	$42,000	$30,000	12000	1900	10100	4040	6060	7960	5980	13310	19290
	4	$43,000	$30,000	13000	1200	11800	4720	7080	8280	5655	15972	21627
	5	$44,000	$30,000	14000	1200	12800	5120	7680	8880	5514	19033	24547
		PW	$ 45,508.77
		FW	$73,292.33
		AW	$12,005.10
Old Lathe
	Year	Revenue	Cash Expense	Cash from Operations before Taxes	Depreciation	Taxable Income	Tax Expense at 40%	Net Income	Cash from Operations after tax (net cash flow)	PV of Net Cash Flow for year	PV of net cash flow for prior years	Cumulative PV
	1	35000	25000	10000	0	10000	4000	6000	6000	5455
	2	35000	25000	10000	0	10000	4000	6000	6000	4959	27500	32459
	3	35000	25000	10000	0	10000	4000	6000	6000	4508	30250	34758
	4	35000	25000	10000	0	10000	4000	6000	6000	4098	33275	37373
	5	35000	25000	10000	0	10000	4000	6000	6000	3726	36603	40328