Assume a situation where a company has an existing asset, A, that has a current net book

Question:

Assume a situation where a company has an existing asset, A, that has a current net book value (original cost less accumulated depredation to date) of $300,000. This asset has a useful life of three additional years. Its estimated disposal (sales) value both today and at the end of three years is zero. Asset B , which would replace A, could be purchased today for $600,000. If purchased, B would generate annual (cash) operating cost savings (pretax) of $280,000 for each year of its three-year useful life. In determining depredation deductions for tax purposes, assume the straight-line method and zero salvage value for both assets. The company is subject to a combined (federal plus state) income tax of 40°A, both for operating income and gains flosses related to the sale of assets. Other than the initial outlay for Asset B, assume that all cash flows (and related tax payments) occur at the end of the year. Assume a weighted-average cost of capital of 10%.

Data

Current net book value (NBV) of asset A ………………………………………………..	$300,000
Estimated salvage value of asset A, end of useful life ………………………………………	$0
Additional life (in years) of asset A ………………………………………………………..	3
Current disposal value, asset A …………………………………………………………..	$0
Disposal value at end of three years, asset A …………………………………………….	$0

Purchase price, asset B …………………………………………………………………….	$600,000
Estimated salvage value of asset B, end of useful life ……………………………………….	$0
Useful life of asset B (in years) …………………………………………………………….	3
Pre-tax cash operating cost savings (per year) …………………………………………….	$280,000

Combined (federal plus state) income tax rate ……………………………………………..	40%
Weighted-average cost of capital (after-tax discount rate) ………………………………….	10.0000%

Required

1. Determine the relevant (i.e., differential) cash flows (after tax) at each of the following three points related to this asset-replacement

decision: (1) project initiation (i.e., time period 0); (2) project operation (i.e., years 1, 2, and 3); and (3) project disposal (termination, end

of year 3).

2. Using the net present value (NPV) decision model, should the company replace asset A with asset B? (Show calculations.)

3. What is the weighted-average cost of capital (WACC) that would make the company indifferent between keeping or replacing asset A?

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