4. Analysis of a replacement project Aa Aa At times firms will need to decide if

Question

4. Analysis of a replacement project Aa Aa 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 Johnson Co. is considering replacing an existing piece of equipment. The project involves the following The new equipment will have a cost of $9,000,000, 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 $50,000 that will be recovered at the end of the project's life (year . The new machine is more efficient, so the fim's incremental eamings 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 eamed using the old equipment. * The project's cost of capital is 13%. . The company's annual tax rate is 40%. 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 + New depreciation $300,000 + Salvage value - Tax on salvage - NWC + Recapture of NWC Total free cash flow $1,680,000 The net present value (NPV) of this replacement project is O-$1,869,000 O-$2,528,648 O-$2,638,589 -$2,198,824

Explanation / Answer

correct answer is option D -2198824

year 0 year 1 year 2 year 3 year 4 year 5 year 6 intial investment 9000000 EBIT 300000 300000 300000 300000 300000 300000 Less: taxes 120000 120000 120000 120000 120000 120000 Add: new depreciation 1500000 1500000 1500000 1500000 1500000 1500000 Less: old depreciation 50000 50000 50000 50000 Add: salvage value 300000 Less: tax on salvage 40000 Less: NWC 50000 Add: recapture of NWC 50000 total free cash flow -8790000 1630000 1630000 1630000 1630000 1680000 1730000 PV factor 1 0.884956 0.783147 0.69305 0.613319 0.54276 0.480319 NPV PV    -8790000 1442478 1276529 1129672 999709.5 911836.7 830951.1 -2198824

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