Question

7. Analysis of a replacement project At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment. In this case, the company will need to perform a replacement analysis to determine which alternative is the best financial decision for the company. Consider the case of Johnson Company: The managers of Johnson Company are considering replacing an existing piece of equipment, and have collected the following information: • The new piece of equipment will have a cost of $1,800,000, and it will be depreciated on a straight-line basis over a period of five years (years 1-5). • The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at year 0) and three 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 5). 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 $20,000 that will be recovered at the end of the project's life (year 5). • The new machine is more efficient, so the incremental increase in earnings before interest and taxes (EBIT) will increase by a total of $600,000 in each of the next five years (years 1-5). (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 required rate of return is 12%. • The company's annual tax rate is 40%.

Answer 1

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Initial Investment	- 18,00,000
EBIT		600,000	600,000	600,000	600,000	600,000
Less: Tax @40%		240,000	240,000	240,000	240,000	240,000
Plus: New machine depreciation		360,000	360,000	360,000	360,000	360,000
Less: Old machine depreciation		50,000	50,000	50,000
Plus: Salvage of Old	300,000
Less: Tax on salvage @40%	120,000
Less: NWC	20,000
Add: Release of NWC						20,000
Total cash flow	- 16,40,000	670,000	670,000	670,000	720,000	740,000
DCF@12%	1	0.893	0.797	0.712	0.636	0.567
PV	- 16,40,000	598,214	534,120	476,893	457,573	419,896
NPV	846,696
The NPV of the replacement is $846,696