Question

LoRusso Co. i 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 is eligible for 100% bonus depreciation so it will be fully depreciated at t 0 The old machine was purchased before the new tax law, so it is 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 25%. 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 -$900,000 Initial investment ЕBIT - Taxes -A Depreciation x T Salvage value - Tax on salvage -NOWC + Recapture of NOWC Total free cash flow The net present value (NPV) of this replacement project is: O $813,515 O$691,488 O $976,218 O$935,542 111 1

Answer 1

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $ 1,200,000 $ 500,000 $500,000 $500,000 $500,000 $500,000 $500,000 $ 125,000 $125,000 $125,000 $125,000 $125,000 $125,000 $ 300,000 $ 12,500 $ 12,500 $ 12,500 $ 12,500 $0 $ 300,000 $ 25,000 $ 45,000 $ 45,000 Initial investment EBIT Less: Taxes Less: Depreciation *Tax Add: Salvage value Less: Tax on salvage Less: Net working capital (NOWC) Add: Recapture NOWC $0 Total free cash flow Discount factor @13% Present value $ (670,000) $362,500 1.000 0.885 $ (670,000) $320,796 $362,500 $362,500 $362,500 $375,000 $420,000 0.783 0.693 0.613 0.543 0.480 $283,891 $ 251,231 $ 222,328 $203,535 $ 201,734 Net present value $ 813,515

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