Nucor

Assignment Question 3

A firm is considering an investment of $28 million (purchase price) in new equipment to replace old equipment with a book value of $12 million and a market value of $20 million. If the firm replaces the old equipment with the new equipment, it expects to save $17.5 million in operating costs in the first year. The amount of these savings will grow at a rate of 12 per cent per year for each of the following three years. The old equipment has a remaining life of four years. It is being depreciated by the straight line method. 33.3 per cent of the original book value of the new equipment will be depreciated in the first year, 39.9 per cent will be depreciated in the second year, 14.8 per cent will be depreciated in the third year, and 12.0 per cent will be depreciated in the final year. The salvage value of both the old equipment and the new equipment at the end of four years is 0. In addition, replacement of the old equipment with the new equipment requires an immediate increase in net working capital of $5 million, which will not be recovered until the end of the four year investment. Assume that the purchase and sale of the equipment occurs today and all other cash flows occur at the end of their respective years. If the firm's after-tax cost of capital is 14 per cent and the firm is subject to a 30 per cent tax rate, find

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4

Cost of new machine = -28 Savings in Operating Costs = 17.5 Savings in Operating Costs = 19.6 Savings in Operating Costs = 21.952 Savings in Operating Costs = 24.58624

Sale of Old Machine = +20 Tax on savings = -5.25 Tax on savings = -5.88 Tax on savings = -6.5856 Tax on savings = -7.375872

Tax on sale =

-2.4 Dep. Tax shield figure = (0.3 x 6.324) = +1.8972 Dep. Tax shield figure = (0.3 x 8.172) = +2.4516 Dep. Tax shield figure = (0.3 x 1.144) = +0.3432

Dep. Tax shield figure = (0.3 x 0.36) = +0.108

NWC = -5

Recovered NWC = +5

Initial Outlay =

-15.4 After tax Incremental Cash Flow = +14.1472 After tax Incremental Cash Flow = +16.1716 After tax Incremental Cash Flow =

+15.7096 After tax Incremental Cash Flow =

+22.318368

Assignment Question 3a

The net investment (initial net outlay)

= -$28 million + $20 million - $2.4 million - $5 million

= - 15.4 million

The initial