Question

4. 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. The company will need to do replacement analysis to determine which option is the best financial decision for the company.

Price Co. is considering replacing an existing piece of equipment. The project involves the following:

•	The new equipment will have a cost of $2,400,000, 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 $30,000 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 $300,000 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.

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Initial investment
EBIT
– Taxes
+ Δ Depreciation × T
+ Salvage value
– Tax on salvage
– NOWC
+ Recapture of NOWC
Total free cash flow

The net present value (NPV) of this replacement project is:

-$740,364

-$871,016

-$1,045,219

-$653,262

Answer 1

Solution :

The net present value (NPV) of this replacement project is : - $ 871,016.08

= - $ 871,016 ( when rounded off to the nearest whole number )

Thus the solution is option 2 = - $ 871,016

Please find the attached screenshot of the excel sheet containing the detailed calculation of the incremental cash flows associated with the replacement of the old equipment with the new equipment. and the NPV of the same.

24.04.2019-Microsoft Excel HOME INSERT PAGE LAYOUT FORMULAS DATA REVIEW VMEW Statement showing calculation of Net Present value Sl.No Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 -2,400,000.00 S 1 Initial investment (1 2 EBIT (2) 3-Taxes (2)0.30 300,000.00300,000.00 300,000.00 300,000.00 $ 300,000.00 $ 300,000.00 90,000.00 120,000.00 $ -90,000.00 90,000.00 -90,000.00 90,000.00 -90,000.00 $ A Depreciation x T(see Working Note 1 below) $ 5 +Salvage value 6-Tax on salvage (see Working Note 2 below) 7-NOWC 8 +Recapture of NOWC 9 Total free cash flow 105,000.00 105,000.00 105,000.00105,000.00 120,000.00 $ 300,000.00 S $ 30,000.00 $ 30,000.00 $ 30,000.00 360,000.00 -2,160,000.00315,000.00315,000.00 315,000.00 315,000.00 330,000.00 (1)+12+3+45+6+ 10|PVF @ 13 % 11 PV of Free cash Flow 0.6931 0.8850 0.7831 0.6133 0.5428 0.4803 $-2,160,000.00278,761.06 246,691.21 218,310.80193,195.40179,110.78 172,914.67 13 NPV-$2,160,000.00278,761.06$ 246,691.21218,310.80+$ 193,195.40+$179,110.78+$172,914.67$871,016.08 12 Working Note 1 : Calculation of Δ Depreciation x T Year 3 Sl.No. Particulars Year 2 Year 5 Year 1 $ 400,000.00400,000.00 400,000.00400,000.00 400,000.00 S-50,000.00 S S350,000.00 350,000.00 350,000.00 $350,000.00 400,000.00 S Year 4 Year 1 Depreciation on New Machine $2,400,000/6 400,000 2 Less:Depreciation on Old Machine $200,000/4 $50,000 3 Incremental Depreciation 4Tax on incremental depreciation @ 30 %-(3) * 30 % 400,000.00 50,000.00 50,000.00 50,000.00 S 20 21 400,000.00 105,000.00105,000.00 105,000.00105,000.00 120,000.00 120,000.00 Working Note 2: Calculation of Tax on 23 24 25 26 e value Sl.No. Particulars Amount $300,000.00 200,000.00 $100,000.00 0.3 $30,000.00 1 Salvage value 2 Less: Book value 3 Profit on sale 28 29 Tax rate : 30 % : 0.30 5 Tax on salvage value - (3)*