Question

In: Finance

At times firms will need to decide if they want to continue to use their current...

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 $30,000 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   
– NWC   
+ Recapture of NWC   
Total free cash flow                     

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

$66,848

$89,131

$102,501

$75,761

Solutions

Expert Solution

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Initial Investment         (1,200,000)
EBIT      300,000      300,000      300,000      300,000      300,000 300,000
Less: Taxes      (90,000)      (90,000)      (90,000)      (90,000)      (90,000)    (90,000)
Plus: Depreciation*T        45,000        45,000        45,000        45,000        60,000     60,000
Salvage Value              300,000
Less: Tax on Salvage -30000
Less: NWC              (30,000)
Plus: Recapture of NWC 30000
Total net cash flow            (960,000)      255,000      255,000      255,000      255,000      270,000 300,000
PVF 1 0.8849558 0.7831467 0.6930502 0.6133187 0.5427599 0.480319
PV of cash flows            (960,000)      225,664      199,702      176,728      156,396      146,545 144,096
NPV                89,131
Hence, the answer is $89,131

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