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. The company will need to do replacement analysis to determine which option is the best financial decision for the company.

Price Co. is considering replacing an existing piece of equipment. The project involves the following:

•	The new equipment will have a cost of $600,000, and it will be depreciated on a straight-line basis over a period of six years (years 1–6).
•	The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at year 0) and four 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 6). 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 (NOWC) of $20,000 that will be recovered at the end of the project's life (year 6).
•	The new machine is more efficient, so the firm’s incremental earnings before interest and taxes (EBIT) will increase by a total of $300,000 in each of the next six years (years 1–6). 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 cost of capital is 13%.
•	The company's annual tax rate is 30%.

Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment.

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial investment
EBIT
– Taxes
+ Δ Depreciation × T
+ Salvage value
– Tax on salvage
– NOWC
+ Recapture of NOWC
Total free cash flow

The net present value (NPV) of this replacement project is:

$488,241

$574,401

$660,561

$689,281

Answer 1

Answer : Correct Option is $574,401

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial Investment	-600000
EBIT		300000	300000	300000	300000	300000	300000
Less : Taxes		-90000	-90000	-90000	-90000	-90000	-90000
Add : Change in Depreciation * Tax rate		15000	15000	15000	15000	30000	30000
Add: Salvage Value	300000
Less : Tax on Salvage	-30000
Less :NOWC	-20000
Recapture of NOWC							20000
Free Cash Flows	-350000	225000	225000	225000	225000	240000	260000
PV Factor @ 13%	1	0.884956	0.783147	0.69305	0.613319	0.54276	0.4803185
PV of Net Cash flows (Inflow)		199115	176208	155936.3	137996.7	130262.4	124882.82
PV of Net Cash flows (Outflow)	-350000
The net present value (NPV) of this project is		=   $ 574401.25 or $574401
NPV = PV of cash inflow - PV of cash outflow
= 924401.25- 350000
=   $ 574401.25