The new equipment will have a cost of $1, 200, 000, and it will be depreciated o

Question

The new equipment will have a cost of $1, 200, 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 $45,000 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 $600, 000 in each of the next six years (years 1-6). 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. The net present value (NPV) of this replacement project is: $957,541 $1, 126,519

Explanation / Answer

Current salvage value of old Machine=$300,000

Current book value of old machine=$200,000

Gain on old machine=$300,000-$200,000=$100,000

Tax on Gain on old machine=$100,000*40%=$40,000

Pv of nth year @r=1/(1+r)n

The Net present value of this replacement is

Particulars Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6 Total Intial Investment         -1,200,000         -1,200,000 EBIT        600,000        600,000        600,000        600,000        600,000        600,000          3,600,000 Less:Taxes       -240,000       -240,000       -240,000       -240,000       -240,000       -240,000         -1,440,000 Add:New depreciation        200,000        200,000        200,000        200,000        200,000        200,000          1,200,000 Less:Old depreciation          -50,000          -50,000          -50,000          -50,000           -200,000 Add:Salavage value             300,000             300,000 Less:Tax on salvage               -40,000               -40,000 Less:NWC               -45,000               -45,000 Add:Recapture of NWC            45,000                45,000 Total Free cash flow           -985,000        510,000        510,000        510,000        510,000        560,000        605,000          2,220,000 PV@13%                1.0000            0.8850            0.7831            0.6931            0.6133            0.5428            0.4803 NPV           -985,000        451,327        399,405        353,456        312,793        303,946        290,593          11,26,519

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