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 is eligible for 100% bonus depreciation so it will be fully depreciated at t = 0. • The old machine was purchased before the new tax law, so it is 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 operating working capital (NOWC) 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 $400,000 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 25%. Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment. - Year o Year 1 Year 2 Year 3 Year 3 Year 4 Year 5 Initial investment EBIT - Taxes = = = = -A = Depreciation хт + Salvage value - Tax on salvage - NOWC Recapture of NOWC

Answer 1

		Present value of Cash Flow=(Cash Flow)/((1+i)^N)
		i=discount Rate =Cost of Capital =13%=0.13
		N=Year of Cash Flow
	N	Year From Today	0	1	2	3	4	5	6
	a	Initial Investment	($2,400,000)
	b	EBIT		$400,000	$400,000	$400,000	$400,000	$400,000	$400,000
	c=b*25%	Taxes		($100,000)	($100,000)	($100,000)	($100,000)	($100,000)	($100,000)
	d=b+c	Incremental annual Cash Flow		$300,000	$300,000	$300,000	$300,000	$300,000	$300,000
	e	Incremental depreciation	$2,400,000	($50,000)	($50,000)	($50,000)	($50,000)
	f=e*25%	Incremental Depreciation tax shield	$600,000	($12,500)	($12,500)	($12,500)	($12,500)	$0	$0
	h	Salvage Value of old machine	$300,000
	i	Tax on salvage Value=(300000-200000)*25%	($25,000)
	j	NOWC	($60,000)
	k	Recapture of NOWC							$60,000
	FCF=a+d+f+h+i+j+k	Total Free Cash flow	($1,585,000)	$287,500	$287,500	$287,500	$287,500	$300,000	$360,000	SUM
	PV=FCF/(1.13^N)	Present Value of Free Cash flow	($1,585,000)	$254,425	$225,155	$199,252	$176,329	$162,828	$172,915	-$394,097
	NPV=Sum of PV	Sum of Present Value of Free Cash Flow	-$394,097
		ANSWER :
		-$394,097