Question

8. Analysis of a replacement project 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 $45,000 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 $400,000 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 $1,200,000    EBIT $400,000    $400,000    $400,000    $400,000    $400,000       – Taxes $140,000    $140,000    $140,000    $140,000    $140,000       + Δ Depreciation × T ? ? ? ? ?    + Salvage value ? – Tax on salvage ? – NWC ? + Recapture of NWC    Total free cash flow ? ? ? ? ? ?    The net present value (NPV) of this replacement project is: a) $370,504 b) $262,440 c) $308,753 d) $355,066

Answer 1

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial Investment	(1,200,000)
EBIT		400,000	400,000	400,000	400,000	400,000	400,000
Less: Taxes		(140,000)	(140,000)	(140,000)	(140,000)	(140,000)	(140,000)
+Change in Dep.*T		52,500	52,500	52,500	52,500	70,000	70,000
Salvage Value	300,000
Less: Tax on Salvage	-35000
Less: NWC	(45,000)
Plus: Recapture of NWC							45000
Total net cash flow	(980,000)	312,500	312,500	312,500	312,500	330,000	375,000
PVF	1	0.8849558	0.7831467	0.6930502	0.6133187	0.5427599	0.4803185
PV of cash flows	(980,000)	276,549	244,733	216,578	191,662	179,111	180,119
NPV	308,753
Hence, the answer is c.