Question

4. Analysis of a replacement project Aa Ac At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment. The company will need to do replacement analysis to determine which option is the best financial decision for the company. Jones Co. is 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 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 (NWC) of $60,000 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 40%.
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Answer 1

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial Investment -1200000 ЕВП 500000 500000 500000 500000 500000 500000 200000 - Тахes 200000 200000 200000 200000 200000 New Depreciation - Old Depreciation Salvage Value Tax on Salvage 200000 200000 200000 200000 200000 200000 50000 50000 50000 50000 300000 40000 60000 NWC Recapture of NWC Total Free Cash Flow 60000 -1000000 450000 450000 450000 450000 500000 560000 New Depreciation Initial Investment/ Useful Life New Depreciation $1,200,000 /6 New Depreciation $200,000 Tax on Salvage Tax Rate (Salvage Value Book Value) Tax on Salvage 40%* ($300,000- $200,000) Tax on Salvage $40,000 Required Rate of Return 13 % NPV -$1,000,000 + $450,000/1.13 $450,000/1.13^2 NPV $878,870 $450,000/1.133 + $450,000/1.13^4+ $500,000/1.13^5 +$560,000/1.13^6 The net present value (NPV) of this replacement project is $878,870