Question

International Foods (IFC) currently processes seafood with a unit it purchased several years ago. The
unit, which originally cost $500,000, currently has a book value of $250,000. IFC is considering
replacing the existing unit with a newer, more efficient one. The new unit will cost $700,000 and will
also require an initial increase in net working capital of $40,000. Additionally, in order to make the
new unit operational shipping and installation costs will require a further $50,000 investment.
The new unit will be depreciated on a straight-line basis over 5 years to a zero balance. The new unit
will have a salvage value of $75,000 at the end of the projects life in 5 years. The existing unit is being
depreciated at a rate of $50,000 per year. IFC can sell the existing machine today for $275,000.
Assume IFC’s tax rate is 30 percent.
If IFC purchases the new unit, annual revenues are expected to increase by $100,000 in annuity (due
to increased capacity), and annual operating costs (exclusive of depreciation) are expected to
decrease by $20,000 in annuity. IFC estimates that in addition it will need to make ongoing
contributions to net working capital in years 1, 2, 3 and 4 in the amount of $10,000. Accumulated net
working capital will be recovered at the end of 5 years. IFC has a company cost of capital that can be
used for discounting purposes of 12%.
In addition the company has to borrow $100,000 to fund the new project. The loan is interest only
requiring monthly payments at an interest rate of 18% per annum. Repayment of the principal will
occur after the sale of the new unit.
Required: Advise whether the company should replace the unit or not? [use an incremental analysis
approach to solve this cash flow analysis]. We will also teach you an alternative approach to that of
the incremental analysis. The approach you will be taught in tutorials will allow you to arrive at the
same answer but will evaluate the two decisions; (1) the decision to keep the old machine; and (2) the
replacement decision; in isolation.

Answer 1

Base on Net present value of the replacement project, its not advice able to undergo it. Please refer to below for detailed calculations.

We have ignored the capital tax on sale of old asset for simplicity.