4. Analysis of a replacement project At times firms will need to decide if they
ID: 2652993 • Letter: 4
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 $1,800,000, 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 $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 40%. Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment.Explanation / Answer
Solution:
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Intial Investment
$ 1,800,000
EBIT
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
-Taxes (40 %)
$ 120,000
$ 120,000
$ 120,000
$ 120,000
$ 120,000
$ 120,000
+ New Depreiation
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
( - ) Old Depreciation
$ 50,000
$ 50,000
$ 50,000
$ 50,000
Nil
Nil
- Salvage value
$ 300,000
( +) Tax on salvage
$ 40,000
( - ) NWC
$ 30,000
+ Recapture of NWC
$ 30,000
Total free cash flow
$ 430,000
$ 430,000
$ 430,000
$ 430,000
$ 480,000
510,000
Present Value of Cashflows @ 13 %
0.88450
0.78315
0.693050
0.61332
0.542760
0.48032
380,530.9735
336,753.0739
298,011.5698
263,727.0529
260,524.7693
244,962.449
Total present value of Cash flows = $ 1,784,510
Initial Investment = $ 1,570,000
NPV = Total present value of Cash flows - Initial Investment
= $ 1,784,510 - $ 1,570,000 = $ 214,510
Particulars
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Intial Investment
$ 1,800,000
EBIT
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
-Taxes (40 %)
$ 120,000
$ 120,000
$ 120,000
$ 120,000
$ 120,000
$ 120,000
+ New Depreiation
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
$ 300,000
( - ) Old Depreciation
$ 50,000
$ 50,000
$ 50,000
$ 50,000
Nil
Nil
- Salvage value
$ 300,000
( +) Tax on salvage
$ 40,000
( - ) NWC
$ 30,000
+ Recapture of NWC
$ 30,000
Total free cash flow
$ 430,000
$ 430,000
$ 430,000
$ 430,000
$ 480,000
510,000
Present Value of Cashflows @ 13 %
0.88450
0.78315
0.693050
0.61332
0.542760
0.48032
380,530.9735
336,753.0739
298,011.5698
263,727.0529
260,524.7693
244,962.449
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.