Question

8. Analysis of a replacement project Dismiss All Please Wait . . . Please Wait... 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 $1,200,000, 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 (NWC) 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 $700,000 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 35%. 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 selector 1    $1,200,000 $52,500 $525,000 $507,500 EBIT selector 2    $700,000 $245,000 $52,500 $100,000 selector 3    $1,200,000 $245,000 $700,000 $52,500 selector 4    $700,000 $400,000 $245,000 $52,500 selector 5    $700,000 $500,000 $245,000 $52,500 selector 6    $700,000 $52,500 $150,000 $245,000 selector 7    $52,500 $245,000 $700,000 $150,000 – Taxes selector 8    $245,000 –$20,000 $35,000 $700,000 selector 9    –$20,000 $700,000 $35,000 $245,000 selector 10    $35,000 –$20,000 $1,200,000 $245,000 selector 11    $245,000 $700,000 –$20,000 $35,000 selector 12    $245,000 $1,200,000 $35,000 –$20,000 selector 13    $35,000 $245,000 –$20,000 $1,200,000 + Δ Depreciation × T selector 14    $52,500 35,000 245,000 –20000 -$955,000 selector 15    525,000 35,000 245,000 –20000 $52,500 selector 16    –20000 245,000 35,000 507,500 $52,500 selector 17    52,500 35,000 525,000 245,000 –20000 selector 18    245,000 70,000 –20000 545,000 35,000 selector 19    –20000 -$955,000 245,000 35,000 70,000 + Salvage value selector 20    $1,200,000 $700,000 $245,000 $300,000 – Tax on salvage selector 21    $300,000 $245,000 $52,500 $35,000 – NWC selector 22    $20,000 $-$955,000 $525,000 $300,000 + Recapture of NWC selector 23    $20,000 $35,000 -$955,000 $525,000 Total free cash flow selector 24    -$955,000 $245,000 $700,000 $52,500 selector 25    $507,500 -$700,000 $245,000 $52,500 selector 26    $52,500 $507,500 -$700,000 $245,000 selector 27    $507,500 $245,000 $52,500 $700,000 selector 28    $245,000 -$700,000 $507,500 $52,500 selector 29    $245,000 -$700,000 $525,000 $52,500 selector 30    $245,000 $700,000 $545,000 $52,500 Points: The net present value (NPV) of this replacement project is: $1,321,520 $1,266,457 $1,101,267 $936,077

Answer 1