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. 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 $60,000 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 30%. 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: $246,635 $328,846 $279,519 $378,173

Explanation / Answer

Cost of new machine 1800000 Life of machine 6 years Depreciation straight line 300000 Book Value of Old machine 200000 Depreciation 50000 for 4 years Current Salvage vlaue 300000 Increase in NWC 60000 will be recovered in year 6 Incremental EBIT 300000 includes depreciation for new machine Cost of capital 13% Annual Tax rate 30% Cash Flows 1 2 3 4 5 6 Incremental EBIT 300000 300000 300000 300000 300000 300000 Difference of EBIT earned by old and new machines (including Depreciation) Savings on old machine depreciation 50000 50000 50000 50000 0 0 This will be a saving as machine is replaced in year 0 Incremental Tax 105000 105000 105000 105000 90000 90000 (incremental ebit+savings on depreciation of old machine)*30% Net Income 245000 245000 245000 245000 210000 210000 Operating cash flows 545000 545000 545000 545000 510000 510000 net income + depreciation on new machine Calculation of Total Cash Flows 0 1 2 3 4 5 6 Initial Investment -1800000 Salvage Value of Old Machine 300000 Invetment in Net Working Capital -60000 Operating Cash Flows 545000 545000 545000 545000 510000 510000 Recovery of Net working capital 60000 Total Cash Flows -1560000 545000 545000 545000 545000 510000 570000 Discounting Factor =(1/1.13^year 1 0.884956 0.783147 0.69305 0.613319 0.54276 0.480319 Discounted Flows -1560000 482300.9 426814.9 377712.3 334258.7 276807.6 273781.6 cash flow * discount factor Net Present Value = sum of discounted cash flows = 611676 If the machine is not replaced Operating Cash flows Incremental EBIT 300000 300000 300000 300000 300000 300000 Depreciation on Old Machine 50000 50000 50000 50000 EBIT (incremental EBIT - Depn) 250000 250000 250000 250000 300000 300000 Tax at 30% 75000 75000 75000 75000 90000 90000 Net Income 175000 175000 175000 175000 210000 210000 Opeerating Cash flows 475000 475000 475000 475000 510000 510000 Total cash flows Intial investment -1800000 Investment in NWC 60000 Operating cash flows 475000 475000 475000 475000 510000 510000 Recovery of NWC 60000 Total flows -1740000 475000 475000 475000 475000 510000 570000 Discount Factor at 13% 1 0.884956 0.783147 0.69305 0.613319 0.54276 0.480319 Discounted flows -1740000 420354 371994.7 329198.8 291326.4 276807.6 273781.6 Net Present Value 223463 Incremental NPV 388213

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