Introduction to Finance

Initial Investment Outlay
Cash outflows for new computer
$12,000
Cash inflow from disposal of old computer
–$3,600
Initial investment outlay
$8,400

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560
C H A PT E R 1 7 Capital Budgeting Analysis
TA B L E L E 1 7 . 5
Incremental After-Tax Operating Cash Flows
Year 1 
Tax rate: 40%
Old System
New System
Incremental 
Cash Flows 
(new – old)
Sales
$500,000
$500,000
$0
–Cost
–$3,000
–$500
$2,500
–Depreciation
–$2,000
–$4,000
–$2,000
SUM
$495,000
$495,500
$500
×(1 – 
T
)
$297,000
$297,300
$300
+Depreciation
$2,000
$4,000
$2,000
–Change NWC
$0
$0
$0
Operating CF
$299,000
$301,300
$2,300
Year 2 
Tax rate: 40%
Old System
New System
Incremental 
Cash Flows 
(new – old)
Sales
$500,000
$500,000
$0
Cost –$3,500
–$2,000
$1,500
Depreciation
–$2,000
–$4,000
–$2,000
SUM
$494,500
$494,000
–$500
×(1 – 
T
)
$296,700
$296,400
–$300
+Depreciation
$2,000
$4,000
$2,000
–Change NWC
$0
$0
$0
Operating CF
$298,700
$300,400
$1,700
Year 3 
Tax rate: 40%
Old System
New System
Incremental 
Cash Flows 
(new – old)
Sales
$500,000
$500,000
$0
Cost –$4,000
–$3,000
$1,000
Depreciation
–$2,000
–$4,000
–$2,000
SUM
$494,000
$493,000
–$1,000
×(1 – 
T
)
$296,400
$295,800
–$600
+Depreciation
$2,000
$4,000
$2,000
–Change NWC
$0
$0
$0
Operating CF
$298,400
$299,800
$1,400
Summary:
t
= 1
t
= 2
t
= 3
Incremental after-tax OCF
$2,300
$1,700
$1,400

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17.13 Applications
561
In Table LE17.5, we apply equation 17.4 to each year. For example, for the fi rst year, we 
list the operating cash fl ow components for the old system: costs of $3,000, depreciation of 
$2,000, and no change in net working capital. We do the same for the new system: costs of 
$500, depreciation of $4,000, and no change in net working capital. The incremental operat-
ing cash fl ow of replacing computer systems in the fi rst year is $2,300. Similarly, we fi nd the 
incremental operating cash fl ows for year two is $1,700 and year three is $1,400.
Salvage Value 
At the end of the third year, we will assume the new computer will have 
a market value of $1,000 whereas the old computer, if kept, will be worthless. Since the old 
computer system will have a book value and a market value of $0, its after-tax salvage value 
is $0.
The new computer’s book value will be zero after three years. Its after-tax salvage value 
will be the selling price of $1,000 less the tax obligation of $400 [0.4($1,000 – $0)], or $600. 
The incremental salvage value cash fl ow will be $600 (new computer) – $0 (old computer), 
or $600.