Identifying Relevant Cash Flows; Asset-Replacement Decision Assume that it is January1, 2019, and that the Mendoza Company is considering the replacement of a machine that has beenused for the past 3 years in a special project for the company. This project is expected to continuefor an additional 5 years (i.e., until the end of 2023). Mendoza will either keep the existing machinefor another 5 years (8 years total) or replace the existing machine now with a new model that has a5-year estimated life. Pertinent facts regarding this decision are as follows:[LO 12-3, 12-8]Keep Existing Machine Purchase New MachinePurchase price of machine (includingtransportation, setup charges, etc.) $150,000 $190,000Useful life (determined at time of acquisition) 8 years 5 yearsEstimated salvage value, end of 2023* $20,000 $25,000Expected cash operating costs, per year:Variable (per unit produced/sold) $0.25 $0.19Fixed costs (total) $25,000 $24,000Estimated salvage (terminal) values:January 1, 2019 $68,000December 31, 2023 $12,000 $22,000Net working capital committed at time ofacquisition of existing machine (all fullyrecovered at end of project, December31, 2023) $30,000Incremental net working capital required ifnew machine is purchased on January 1,2019 (all fully recovered at end of project,December 31, 2023) $10,000Expected annual volume of output/sales(in units), over the period 2019–2023 500,000 500,000*These amounts are used for depreciation calculations.Assume further that Mendoza is subject to a 40% income tax, both for ordinary income and gains/losses associated with disposal of machinery, and that all cash flows occur at the end of the year,except for the initial investment. Assume that straight-line depreciation is used for tax purposesand that any tax associated with the disposal of machinery occurs at the same time of the relatedtransaction.Required Determine the relevant cash flows (after-tax) at: (1) time of purchase of the new machine (i.e.,time 0: January 1, 2019), (2) Determine the relevant (after-tax) cash inflow each year of project operation(i.e., at the end of each of years 1 through 5), (3) Determine the relevant (after-tax) cash inflow at the end ofthe project’s life (i.e., at the project’s disposal time, December 31, 2023), (4) Identify any irrelevant cost andrevenue data associated with this asset-replacement decision, (5) Determine the undiscounted net cash flow(after tax) for the new machine and determine whether on this basis the old machine should be replaced.
Identifying Relevant
1, 2019, and that the Mendoza Company is considering the replacement of a machine that has been
used for the past 3 years in a special project for the company. This project is expected to continue
for an additional 5 years (i.e., until the end of 2023). Mendoza will either keep the existing machine
for another 5 years (8 years total) or replace the existing machine now with a new model that has a
5-year estimated life. Pertinent facts regarding this decision are as follows:
[LO 12-3, 12-8]
Keep Existing Machine Purchase New Machine
Purchase price of machine (including
transportation, setup charges, etc.) $150,000 $190,000
Useful life (determined at time of acquisition) 8 years 5 years
Estimated salvage value, end of 2023* $20,000 $25,000
Expected cash operating costs, per year:
Variable (per unit produced/sold) $0.25 $0.19
Fixed costs (total) $25,000 $24,000
Estimated salvage (terminal) values:
January 1, 2019 $68,000
December 31, 2023 $12,000 $22,000
Net
acquisition of existing machine (all fully
recovered at end of project, December
31, 2023) $30,000
Incremental net working capital required if
new machine is purchased on January 1,
2019 (all fully recovered at end of project,
December 31, 2023) $10,000
Expected annual volume of output/sales
(in units), over the period 2019–2023 500,000 500,000
*These amounts are used for
Assume further that Mendoza is subject to a 40% income tax, both for ordinary income and gains/
losses associated with disposal of machinery, and that all cash flows occur at the end of the year,
except for the initial investment. Assume that straight-line depreciation is used for tax purposes
and that any tax associated with the disposal of machinery occurs at the same time of the related
transaction.
Required Determine the relevant cash flows (after-tax) at: (1) time of purchase of the new machine (i.e.,
time 0: January 1, 2019), (2) Determine the relevant (after-tax)
(i.e., at the end of each of years 1 through 5), (3) Determine the relevant (after-tax) cash inflow at the end of
the project’s life (i.e., at the project’s disposal time, December 31, 2023), (4) Identify any irrelevant cost and
revenue data associated with this asset-replacement decision, (5) Determine the undiscounted net cash flow
(after tax) for the new machine and determine whether on this basis the old machine should be replaced.
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