A firm believes it can generate an additional $240,000 per year in revenues for

Question

A firm believes it can generate an additional $240,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $260,000. The firm expects to be able to sell the new equipment when it is finished using it (after 5 years) for $10,000. The existing equipment has a book value of $25,000 and a market value of $20,000. Variable costs are expected to total 65% of revenue. The additional sales will require an initial investment in net working capital of $20,000, which is expected to be recovered at the end of the project (after 5 years). Assume the firm uses straight line depreciation, its marginal tax rate is 30%, and its weighted-average cost of capital is 10%.

a) How much value will this new equipment create for the firm?

b) At what discount rate will this project break even?

c) Should the firm purchase the new equipment? Be sure to justify your recommendation

Explanation / Answer

When we sell old equipment, tax benefit on the loss = (25,000-20,000)*30% = 1500

So after tax salvage value = 20,000+1,500 = 21,500

Initial year 0 cashflow = - spend on new equipment + after tax salvage value - working capital = -260,000+21,500 - 20,000 = -258,500

Annual depreciation = (260,000-10,000)/5 = 50,000

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