Lombard Company is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The existing grinder was purchased 2 years ago at an installed cost of $105,000; it was being depreciated under the straight line method. The existing grinder is expected to have a usable life of 7 years.

The new grinder costs $150,000 and requires $7,500 in installation costs; it has a 5-year usable life and would be depreciated under straight line method with its 5-year useful life. Lombard can currently sell the existing grinder for $70,000 without incurring any removal or clean-up costs. $5,000 one off payment has to be incurred at the introduction of the new machine to re-train the existing machine operators. This expenses can be fully deducted from the year one cash flows for the taxation purpose.

To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by $40,000, inventories by $30,000, and accounts payable by $58,000.

At the end of 5 years, the existing grinder would have a market value of zero; the new grinder would be sold to net $29,000 after removal and clean-up costs and before taxes. The investment in the working capital can be fully recovered at the end of year 5. The firm is subject to a 40% tax rate.The company's cost of capital is 8%.

The estimated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the following table.

Earnings before depreciation, interest, and taxes

Year

New grinder

Existing grinder

1

2

3

4

5

$53,000

53,000

53,000

53,000

53,000

$26,000

24,000

22,000

20,000

18,000

a.Calculate the initial investment associated with the replacement of the existing grinder by the new one.

b.Determine the incremental operating cash flows associated with the proposed grinder replacement.

c.Determine the terminal cash flow expected at the end of year 5 from the pro- posed grinder replacement.

d.Evaluate the project.