1. **Problem Statement:** TelCo must decide whether to replace a computer system with a new model. The new computer costs 1,000,000 and TelCo is eligible for a 15% investment tax credit (ITC). The old computer can be sold for 450,000, originally cost 1,250,000, and is three years old with a five-year straight-line depreciation to zero salvage value. The cost of capital is 12%, and the tax rate is 35%. Forecasted before-tax cost savings over five years are 350,000 for years 1 and 2, and 300,000 for years 3 to 5. 2. **Calculate Net Investment Required:** - ITC = 15% of 1,000,000 = 150,000 - Book value of old computer = Original cost - Accumulated depreciation - Annual depreciation = 1,250,000 / 5 = 250,000 - Accumulated depreciation for 3 years = 3 × 250,000 = 750,000 - Book value = 1,250,000 - 750,000 = 500,000 - Gain/loss on sale = Sale price - Book value = 450,000 - 500,000 = -50,000 (loss) - Tax shield on loss = 35% × 50,000 = 17,500 - After-tax salvage value = Sale price + Tax shield = 450,000 + 17,500 = 467,500 - Net investment = Cost of new computer - ITC - After-tax salvage value = 1,000,000 - 150,000 - 467,500 = 382,500 3. **Estimate Incremental Operating Cash Flows:** - Annual before-tax savings: Years 1-2 = 350,000; Years 3-5 = 300,000 - Depreciation on new computer = 1,000,000 / 5 = 200,000 per year - Taxable savings = Before-tax savings - Depreciation - Tax on savings = Taxable savings × 35% - After-tax savings = Before-tax savings - Tax on savings - Add back depreciation (non-cash expense) to get operating cash flow Calculate for each year: Year 1-2: Taxable savings = 350,000 - 200,000 = 150,000 Tax = 150,000 × 0.35 = 52,500 After-tax savings = 350,000 - 52,500 = 297,500 Operating cash flow = 297,500 + 200,000 = 497,500 Year 3-5: Taxable savings = 300,000 - 200,000 = 100,000 Tax = 100,000 × 0.35 = 35,000 After-tax savings = 300,000 - 35,000 = 265,000 Operating cash flow = 265,000 + 200,000 = 465,000 4. **Decision on Purchase Considering Salvage Value:** - Salvage value at end of year 5 = 100,000 - Book value at year 5 = 0 (fully depreciated) - Gain on sale = 100,000 - 0 = 100,000 - Tax on gain = 100,000 × 0.35 = 35,000 - After-tax salvage value = 100,000 - 35,000 = 65,000 5. **Summary Table of Cash Flows:** | Year | Before-tax Savings | Depreciation | Taxable Savings | Tax (35%) | After-tax Savings | Operating Cash Flow | |-------|--------------------|--------------|-----------------|-----------|-------------------|--------------------| | 1 | 350,000 | 200,000 | 150,000 | 52,500 | 297,500 | 497,500 | | 2 | 350,000 | 200,000 | 150,000 | 52,500 | 297,500 | 497,500 | | 3 | 300,000 | 200,000 | 100,000 | 35,000 | 265,000 | 465,000 | | 4 | 300,000 | 200,000 | 100,000 | 35,000 | 265,000 | 465,000 | | 5 | 300,000 | 200,000 | 100,000 | 35,000 | 265,000 | 465,000 | 6. **Conclusion:** - Net investment required is 382,500 - Annual operating cash flows are 497,500 for years 1 and 2, and 465,000 for years 3 to 5 - At the end of year 5, an after-tax salvage value of 65,000 is expected - TelCo should compare the net present value (NPV) of these cash flows at 12% cost of capital to decide on purchase (not requested here but recommended) Final answers: - Net investment required: 382,500 - Operating cash flows: 497,500 (years 1-2), 465,000 (years 3-5) - After-tax salvage value: 65,000