At times firms will need to decide if they want to continue to use their current

Question

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. Jones 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 depredated on a straight-line basis over a period of six years (years 1-6). The old machine is also being depredated on a straight-line basis. It has a book value of $200,000 (at year 0) and four more years of depredation 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 6). The new machine is more efficient, so the firm's incremental earnings before interest and taxes (EBIT) will increase by a total of $700,000 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 35%. 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:

Explanation / Answer

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total Initial investement -1800000 EBIT 0 700000 700000 700000 700000 700000 700000 Taxes 0 -245000 -245000 -245000 -245000 -245000 -245000 New Depreciation 0 300000 300000 300000 300000 300000 300000 Old depreciation 0 -50000 -50000 -50000 -50000 0 0 Salvage value 300000 Tax on SalvageValue* -35000 Net Working Capital -50000 Recapture of NWC 0 0 0 0 0 0 50000 Total free cash flow -1585000 705000 705000 705000 705000 755000 805000 Discount rate at 13% 1 0.884956 0.783147 0.69305 0.613319 0.54276 0.480319 Discounted cash flow -1585000 623893.8 552118.4 488600.4 432389.7 409783.8 386656.4 1308442 * tax on salvage = Profit on sale (300000 - 200000 Book value) i.e. $100000 * 35% tax = $35000 NPV = $1308442

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