In: Finance
4. Johnson 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 $50,000 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 (year 1-6). Hint: This value represents the difference between the revenues and operating costs (including depreciation expense) generated using the new equipment and that earning using the old equipment.
- The projects cost of capital is 13%.
- The company's annual tax rate is 30%.
a. Complete the following table and computer 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 |
________ |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
EBIT |
NoAnswerNeeded |
________ |
________ |
________ |
________ |
________ |
_700,000 |
- taxes |
NoAnswerNeeded |
________ |
________ |
________ |
________ |
________ |
________ |
+ new depreciation |
NoAnswerNeeded |
________ |
________ |
________ |
________ |
________ |
________ |
- old depreciation |
NoAnswerNeeded |
________ |
________ |
________ |
________ |
NoAnswerNeeded |
NoAnswerNeeded |
+ salvage value |
________ |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
- tax on salvage |
________ |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
- NWC |
________ |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
+ recapture of NWC |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
NoAnswerNeeded |
________ |
Total free Cash Flows |
________ |
________ |
________ |
________ |
________ |
690,000 |
________ |
b. The net present value (NPV) of this replacement project
is:
a. $1,901,642
b. $1,405,562
c. $1,653,602
d. $1,240,202
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
Initial investment | -1200000 | ||||||
EBIT | 700000 | 700000 | 700000 | 700000 | 700000 | 700000 | |
Less: Taxes @ 30% on EBIT | -210000 | -210000 | -210000 | -210000 | -210000 | -210000 | |
Add: New depreciation | 200000 | 200000 | 200000 | 200000 | 200000 | 200000 | |
Less: Old depreciation | -50000 | -50000 | -50000 | -50000 | |||
Add: Salvage value | 300000 | ||||||
Less: Tax on salvage value | -30000 | ||||||
Less: Net working capital | -50000 | ||||||
Add: Recapture of net working capital | 50000 | ||||||
Total free cash flows | -980000 | 640000 | 640000 | 640000 | 640000 | 690000 | 740000 |
New depreciation = (Cost-Salvage value)/Useful life | |||||||
New depreciation | (1200000-0)/6 | ||||||
New depreciation | 200000 | ||||||
Calculation of tax on salvage value | |||||||
Book value of old equipment | 200000 | ||||||
Less: Salvage value today | 300000 | ||||||
Gain on sale | 100000 | ||||||
Tax on gain @ 30% | 30000 | ||||||
Calculation of net present value of equipment | |||||||
Year | Cash flow | Discount factor @ 13% | Present value | ||||
0 | -980000 | 1.00000 | 1/(1.13^0) | -$980,000 | |||
1 | 640000 | 0.88496 | 1/(1.13^1) | $566,372 | |||
2 | 640000 | 0.78315 | 1/(1.13^2) | $501,214 | |||
3 | 640000 | 0.69305 | 1/(1.13^3) | $443,552 | |||
4 | 640000 | 0.61332 | 1/(1.13^4) | $392,524 | |||
5 | 690000 | 0.54276 | 1/(1.13^5) | $374,504 | |||
6 | 740000 | 0.48032 | 1/(1.13^6) | $355,436 | |||
NPV | $1,653,602 | ||||||
The NPV of the equipment is $1,653,602 | |||||||