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 $9,000,000, 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 $500,000 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	$9,000,000
EBIT		$500,000	$500,000	$500,000	$500,000	$500,000	$500,000
– Taxes		$150,000	$150,000	$150,000	$150,000	$150,000	$150,000
+ Δ Depreciation × T
+ Salvage value
– Tax on salvage
+ Recapture of NWC
Total free cash flow

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

-$6,704,365

-$4,190,228

-$4,748,925

-$5,586,971

Answer 1

Answer : Correct Option is $-5586971

Calculations :

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial Investment	9000000
EBIT		500000	500000	500000	500000	500000	500000
Less : Taxes @30%		150000	150000	150000	150000	150000	150000
Add : Change in Depreciation * Tax rate (1500000-50000)*0.30		435000	435000	435000	435000	450000	450000
Add :Salvage Value	300000
Less: Tax on Gain on Sale [(300000 - 200000)* 30%]	30000
Less : NOWC	20000
Add: Recapture of NOWC							20000
Free Cash Flows	8750000	785000	785000	785000	785000	800000	820000
PV Factor @ 13%	1	0.884956	0.783147	0.69305	0.613319	0.54276	0.480319
PV of Net Cash flows (Inflow)		694690.3	614770.1	544044.4	481455.2	434207.9	393861.2
PV of Net Cash flows (Outflow)	8750000
The net present value (NPV) of this project is		= $ -5586970.868 or $-5586971
NPV = PV of cash inflow - PV of cash outflow
= 3163029.132- 8750000
= $ -5586970.868 or $-5586971