Cost Management 6th Edition by Edward Blocher,David Stout ,Paul Juras,Gary Cokins

Exercise 59

Asset-Replacement Decision; NPV Analysis Assume a situation in which a company has an existing asset, A, that has a current net book value (original cost less accumulated depreciation 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 depreciation 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%, both for operating income and gains/losses 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%.
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 (time period 0), (2) project operation, and (3) project disposal (termination, time period 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