Question

In: Finance

4. Johnson Co. is considering replacing an existing piece of equipment. The project involves the following:...

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

Solutions

Expert Solution

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

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