Two years ago our company bought equipment for $1 million that has been depreciated straight line over a five-year life. The equipment has a current market value of $300,000. More efficient equipment can be purchased today for $3 million and is expected to last 5 years (economic life), at which time its anticipated salvage value would be $300,000. However, the new equipment would be depreciated straight line over only four years to a zero salvage value. Our company would realize a $1,000,000 per year operating cost savings by replacing the old equipment with the new equipment. Also, our Net Working Capital Requirement would decrease by $75,000 as soon as we bought the equipment, but would increase again when it is sold at the end of its economic life (5 years). Our marginal tax rate is 30%. Identify the relevant cash flows for this project.

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The Answer of Two years ago our company bought equipment for $1 million that has been depreciated straight line over a five-year life. The equipment has a current market value of $300,000. More efficient equipment can be purchased today for $3 million and is expected to last 5 years (economic life), at which time its anticipated salvage value would be $300,000. However, the new equipment would be depreciated straight line over only four years to a zero salvage value. Our company would realize a $1,000,000 per year operating cost savings by replacing the old equipment with the new equipment. Also, our Net Working Capital Requirement would decrease by $75,000 as soon as we bought the equipment, but would increase again when it is sold at the end of its economic life (5 years). Our marginal tax rate is 30%. Identify the relevant cash flows for this project.

Two Years Ago Our Company Bought Equipment for $1 Million