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    Cash flows and NPV for a replacement decision

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    Andrew Thompson Interests (ATI) is using a mechanical switching system that it bought five years ago for $400,000. This mechanical system is being depreciated straight line to an estimated salvage value of zero over a 10-year life. Thus, the annual depreciation charge is $40,000 and current book value is $200,000. At the end of its life, the actual salvage value is expected to be $25,000. If ATI sold this equipment today, it would fetch $100,000.

    ATI is evaluating a new digital switching system that will cost $500,000. The digital system is depreciated straight line to a zero salvage value over a five-year life. At the end of the five years, ATI expects to sell the system for $150,000. The new digital system should have a favorable impact on operating cash flows, increasing revenues by $100,000 annually and decreasing cash operating expenses by $50,000 annually. The new equipment has no effect on the investment in working capital.

    ATI is in the 40% tax bracket and has a 12% cost of capital. Consider each of the following questions assuming that ATI sells the old mechanical switching system and replaces it with the new digital system.
    1. What is the net investment?
    2. What is the after-tax net operating cash flow for each of the five years?
    3. What is the after-tax salvage value?
    4. What is the NPV of this investment?

    Please give a detailed response, how was the problem solved, what functions were used in excel, what formulas were used.

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    Solution Summary

    The solution examines the cash flows and NPV for a replacement decisions.