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 $2,400,000, 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 operating working capital (NOWC) 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 $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 40%.

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	$2,400,000
EBIT		$500,000	$500,000	$500,000	$500,000	$500,000	$500,000
– Taxes
+ New depreciation
– Old depreciation
+ Salvage value	300,000
– Tax on salvage
– NOWC	45000
+ Recapture of NOWC
Total free cash flow						$700,000	The net present value (NPV) of this replacement project is: $583,411. $364,632. $486,176. $413,250.

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

-$583,411.

-$364,632.

-$486,176.

-$413,250.

Answer 1

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial Investment	(2,400,000)
EBIT		500,000	500,000	500,000	500,000	500,000	500,000
Less: Taxes		(200,000)	(200,000)	(200,000)	(200,000)	(200,000)	(200,000)
Plus: New Depreciation		400,000	400,000	400,000	400,000	400,000	400,000
Less: Old Depreciation		(50,000)	(50,000)	(50,000)	(50,000)
Salvage Value	300,000
Less: Tax on Salvage	-40000
Less: NWC	(45,000)
Plus: Recapture of NWC						45,000
Total net cash flow	(2,185,000)	650,000	650,000	650,000	650,000	745,000	700,000
PVF	1	0.8849558	0.7831467	0.6930502	0.6133187	0.5427599	0.480319
PV of cash flows	(2,185,000)	575,221	509,045	450,483	398,657	404,356	336,223
NPV	488,985
Hence, the answer is $486,176 approx.