Question

(Estimated time allowance: 40-50 minutes) Easy-Chair Corp. is considering replacing its existing equipment that is used to produce comfort recline chairs. This existing equipment was purchase 2 years ago at a base price of $100,000. Installation costs at the time for this old equipment were $5,000. The existing equipment is considered a 5-year class for MACRS. The existing equipment can be sold today for $40,000 and for $0 in 3 years. The new equipment has a purchase price of $200,000 and is also considered a 5-year class for MACRS. Installation costs for the new equipment are $10,000. It is estimated that this equipment can be sold in 3 years (end of project) for $70,000. This new equipment is more efficient than the existing one and thus savings before taxes using the new machine are $20,000 a year. This new equipment will also require additional working capital today of $12,000; this investment will be recovered at the end of the project in year 3. The company's marginal tax rate is 20% and the cost of capital is 10%.

What is the NPV of this replacement project? The following 6 questions reach the value for the answer.

MACRS Fixed Annual Expense Percentages by Recovery Class
Year	3-Year	5-Year	7-Year	10-Year	15-Year
1	33.33%	20.00%	14.29%	10.00%	5.00%
2	44.45%	32.00%	24.49%	18.00%	9.50%
3	14.81%	19.20%	17.49%	14.40%	8.55%
4	7.41%	11.52%	12.49%	11.52%	7.70%
5		11.52%	8.93%	9.22%	6.93%
6		5.76%	8.93%	7.37%	6.23%
7			8.93%	6.55%	5.90%
8			4.45%	6.55%	5.90%
9				6.56%	5.91%
10				6.55%	5.90%
11				3.28%	5.91%
12					5.90%
13					5.91%
14					5.90%
15					5.91%
16					2.95%

For your answer, round to the nearest dollar, do not enter the $ sign, use commas to separate thousands, use a negative sign in front of first number is the cash flow is negative (do not use parenthesis to indicate negative cash flows). For example, if your answer is $3,005.87 then enter 3,006; if your answer is -$1,200.25 then enter -1,200

1. What is the initial outlay (I0) for this project - the project cash flows at time = 0?

2. What is the free cash flow (FCF) for year 1 of this replacement project?

3. What is the free cash flow (FCF) for year 2 of this replacement project?

4. What is the net operating profit plus incremental depreciation for year 3 of this replacement project?

5. What is the free cash flow (FCF) for year 3 of this replacement project?

6. What is the NPV of this replacement project?

Answer 1

		0	1	2	3
	Annual savings for taxes		$            20,000	$           20,000	$           20,000
	Incremental depreciation:					Accu: Depn:	Book Value
	Depreciation of new equipment [on $210,000]		$            42,000	$           67,200	$           40,320	$        149,520	$           60,480
	Depreciation of old equipment [on $105,000]		$            20,160	$           12,096	$           12,096	$          98,952	$             6,048
	-Incremental depreciation:		$            21,840	$           55,104	$           28,224
	=Incremental NOI		$            (1,840)	$         (35,104)	$           (8,224)
	-Tax at 20%		$                (368)	$           (7,021)	$           (1,645)
	=Incremental NOPAT		$            (1,472)	$         (28,083)	$           (6,579)
	+Incremental depreciation		$            21,840	$           55,104	$           28,224
	=Incremental OCF		$            20,368	$           27,021	$           21,645
	-Capital expenditure-Cost of new equipment	$           210,000
	+After tax salvage value of old equipment [see workings given below]	$             42,080
	+After tax salvage value of new equipment = 70000-(70000-60480)*20% =				$           68,096
	-Loss of tax shield on loss on scrapping of old equipment (6048*20%)				$              1,210
	-Change in NWC	$             12,000			$         (12,000)
	=FCF	$         (179,920)	$            20,368	$           27,021	$         100,531
	PVIF at 10%	1	0.90909	0.82645	0.75131
	PV of FCF	$         (179,920)	$            18,516	$           22,331	$           75,531
	NPV of the replacement	$           (63,542)
	ANSWERS:
1]	Initial outlay = 210000-42080+12000 =	$           179,920
2]	FCF for year 1	$             20,368
3]	FCF for year 2	$             27,021
4]	OCF for year 3	$             21,645
5]	FCF for year 3	$           100,531
	WORKINGS:
1]	After tax salvage value of old equipment:
	Salvage value	$             40,000
	Book value = 105000*(19.2%+11.52%+11.52%+5.76%) =	$             50,400
	Loss on sale	$             10,400
	Tax shield on loss at 20%	$ 2,080
	After tax salvage value of old equipment:	$             42,080