Question

• The new equipment will have a cost of $600,000, 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 (NOWC) of $20,000 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 30%. Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment.

Answer 1

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial Investment -6,00,000 EBIT Less: Taxes @30% Add: Change in Depreciation 5.00.000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 -1,50,000 -1,50,000 -1,50,000 -1,50,000 -1,50,000 -1.50.000 50,000 50,000 50,000 50,000 1,00,000 1,00,000 3,00,000 -30,000 Salvage Value Less: Tax on salvage value (Assuming the same as Annual tax rate i.e. 30% on capital gain) = (3,00,000 -2,00,000) * 30% = 30,000 Less: NOWC -20,000 Add: Recapture of NOWC 20.000 Total Cash inflow -3,50,000 4,00,000 4,00,000 4,00.000 4,00,000 4,50,000 4,70,000 Present value factor @ 13% 1 0.88496 0.78315 0.69305 0.61332 0.54276 0.48032 Present value of cash inflows -3,50,000 3,53,984 3.13.260 2,77,220 2.45,328 2.44.242 2,25,750 13,09,784 Hence, the NPV of this Replace project is $13,09,784 (Approximtely)