Problem:
A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be fully depreciated over its five year life using the straight-line method.
The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital during the asset's life of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life.
The existing asset was originally purchased three years ago for $25,000, has a remaining life of five years, and is being depreciated using the straight-line method. The expected salvage value at the end of the asset's life (i.e., five years from now) is $5,000; however, the current sale price of the existing asset is $20,000, and its current book value is $15,625. The firm's marginal tax rate is 34 percent and its required rate of return is 12 percent.
Required:
Question 1: Calculate the change in depreciation expense if the new machine is purchased?
Question 2: Calculate the change in taxes on the sale of the old machine?
Question 3: Calculate the change in operating cash flow for years 1 through 5 if the new machine is purchased?
Note: Provide support for your underlying principle.