Question

At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment. In this case, the company will need to perform a replacement analysis to determine which alternative is the best financial decision for the company.

Consider the case of Price Company

: The managers of Price Company are considering replacing an existing piece of equipment, and have collected the following information:

• The new piece of equipment will have a cost of $9,000,000, and it will be depreciated on a straight-line basis over a period of five years (years 1–5).

• The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at year 0) and three more years of depreciation left ($50,000 per year).

• The new equipment will have a salvage value of $0 at the end of the project's life (year 5). The old machine has a current salvage value (at year 0) of $300,000.

• Replacing the old machine will require an investment in net working capital (NWC) of $60,000 that will be recovered at the end of the project's life (year 5).

• The new machine is more efficient, so the incremental increase in earnings before interest and taxes (EBIT) will increase by a total of $600,000 in each of the next five years (years 1–5). (Hint: This value represents the difference between the revenues and operating costs (including depreciation expense) generated using the new equipment and that earned using the old equipment. )

• The project's required rate of return is 8%.

• The company's annual tax rate is 30%
.

PT I

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Initial Investment	$2,280,000/$9,000,000/$1,800,000/$600,000
EBIT		$100,000/$1,800,000/$9,000,000/$600,000	$9,000,000/$600,000/$100,000/$1,800,000	$600,000/$100,000/$1,800,000/$9,000,000	$9,000,000/$600,000/$100,000/$1,800,000	$600,000
Less: Taxes		180,000/1,800,000/60,000/9,000,000	1,800,000/9,000,000/180,000/60,000	1,800,000/60,000/180,000/9,000,000	1,800,000/60,000/180,000/9,000,000	1,800,000/60,000/180,000/9,000,000
Plus: New Depreciation		30,000/1,800,000/-60,000/180,000	180,000/-60,000/1,800,000/30,000	1,800,000/-60,000/180,000/30,000	1,800,000/-60,000/30,000/180,000	30,000/1,800,000/-60,000/180,000
Less: Old Depreciation		300,000/50,000/180,000/-60,000	50,000/300,000/-60,000/180,000	180,000/-60,000/50,000/300,000
Plus: Salvage Value	1,800,000/180,000/300,000/2,280,000
Less: Tax on Salvage	300,000/1,800,000/180,000/30,000
Less: NWC	2,280,000/1,800,000/300,000/60,000
Plus: Recapture of NWC						-8,790,000/60,000/30,000/2,280,000
Total Net Cash Flow	$-8,790,000/$1,800,000/$180,000/$9,000,000	$9,000,000/$1,800,000/$2,170,000/$600,00	$9,000,000/$600,000/$1,800,000/$2,170,000	$2,170,000/$1,800,000/$9,000,000/$180,000	$2,220,000	$9,000,000/$1,800,000/$600,000/$2,280,000

************ BOLDED NUMBERS ARE THE CHOICES PER BOX **************

PART II

The net present value (NPV) of this replacement project is $12,073/$-16,335/$-14,204/$-10,653

Answer 1

Net present value of this replacement project is $-14,204.

New Depreciation = (initial cost - salvage value)/no. of years = ($9,000,000 - $0)/5 = $1,800,000

Tax on salvage value = (Market value - book value)*tax rate = ($300,000 - $200,000)*30% = $100,000*30% = $30,000

Excel formula of NPV: "=NPV(discount rate, cash flows)+initial investment"

Initial investment in the above formula should be negative value.

	Years	0	1	2	3	4	5	Total
	Initial investment	$9,000,000						$9,000,000
	EBIT	$0	$600,000	$600,000	$600,000	$600,000	$600,000	$3,000,000
Less:	Taxes @30%	$0	$180,000	$180,000	$180,000	$180,000	$180,000	$900,000
Plus:	New Depreciation	$0	$1,800,000	$1,800,000	$1,800,000	$1,800,000	$1,800,000	$9,000,000
Less:	Old Depreciation	$0	$50,000	$50,000	$50,000	$0	$0	$150,000
Plus:	Salvage value	$300,000	$0	$0	$0	$0	$0	$300,000
Less:	Tax on Salvage value	$30,000	$0	$0	$0	$0	$0	$30,000
Less:	NWC	$60,000	$0	$0	$0	$0	$0	$60,000
Plus:	Recapture of NWC	$0	$0	$0	$0	$0	$60,000	$60,000
	Total cash flows	-$8,790,000	$2,170,000	$2,170,000	$2,170,000	$2,220,000	$2,280,000	$2,220,000
	NPV	-$14,204