Question

The management of Mega Builders is considering replacing an old piece of equipment. The following information is provided :

• The equipment it wants to replace(old equipment) was purchased 5 years ago for $1.5m. It had a useful life of 15 years and the company applies straight-line depreciation with zero salvage value. The equipment’s current market value is $1.2m. If the company keeps using it, this piece of equipment will generate annual sales of $200,000 and incur annual cash operating expense of $120,000. At the end of its useful life, the company expects to sell the equipment for $125,000
• The new equipment will cost $2.5m and will be depreciated on a straight-line basis over 10 years with zero salvage value. The company expects to be able to sell it for $600,000 after 10 years. The new equipment will require an additional investment of $200,000 in working capital (on top of the working capital invested in the old equipment). It is expected to generate annual sales of $600,000 and require annual cash operating expenses of $300,000
• The company’s marginal tax rate is 40%. Given a required rate of return of 10 %, determine wheter the company should replace the old equipment with new one.

Answer 1

Current book value of 5 year old equipment = $1.5 million – (1.5/15)*5=$1 million

Investment Outflow incurred due to replacement = Cost of new equipment + NWC(oldequip) – current value of old equipment + tax on (current value- book value)

                       = 2500000 + 200000- 1200000 + 40% *(1200000-1000000)

                       = $ 1.58 million

Next we will calculate operating cash flow after tax (for replacement)

Here, we will consider only change in the cash flow due to replacement as we are focusing on either to replace the equipment or not.

Change in cash flow (in flow) = change in (sales – expense)*(1-tax) + (change in depreciation)*tax

                                     = [(600000-300000)-(200000-120000)] * (1-0.4) + (250000-100000)*(.4)

                                     = $192000

Cash inflow over the selling price of old equipment at the end of project:

600000- 125000 =$475000

Cash flows due to increment in taxes:

0.4*(600000-0) -0.4*(125000-0)

= $ 190000

Cash flow due to investment on new equipment = $200000

Tax non-operating cash flow = 475000 -190000 (tax saving) + 200000

= $ 485000

NPV of the project = -Investment outflow + PV of inflows

= -1580000 + 192000/(1.1^1) + 192000/(1.1^2) + 192000/(1.1^3) + 192000/(1.1^4) + 192000/(1.1^5) + 192000/(1.1^6) + 192000/(1.1^7) + 192000/(1.1^8) + 192000/(1.1^9) + 192000/(1.1^10)+ 485000/(1.1^10)

=-$ 213254.6203

IRR = 7.1778%

I would not recommend to replace the equipment as NPV is negative and IRR is less than cost of capital.

Negative NPV value shows that replaced equipment will not increase the value of the project in monetary terms.