LoRusso Co. is considering replacing an existing piece of equipment. The project
ID: 2721831 • Letter: L
Question
LoRusso Co. is considering replacing an existing piece of equipment. The project involves the following:
- The new equipment will have a cost of $2,400,000, and it will be depreciated on a straight-line basis over a period of six years.
- The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at time 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 could be sold today and it has a current salvage value (at year 0) of $300,000.
- Replacing the old machine will require an investment in net operating working capital (NOWC) 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 $400,000 in each of the next 6 years.
- The company's annual corporate income tax rate is 40%.
What is the FCF at time 0 for this potential replacement project? Hint: the components that should go in your calculation include incremental CapEx at time 0 (investment in the new equipment minus the after-tax salvage value of the old equipment) and the change in NOWC.
-$2,000,000Explanation / Answer
Hence, the correct answer is Option C -$2,200,000
Cost of New Machine (a) $2,400,000 Post tax Salvage Value of Old Machine (b) $260,000 Replacement Cost (c = a-b) $2,140,000 Net Working Captial Requirement (d) $60,000 Free Cashflow at Year 0 (e = c+d) $2,200,000 Salvage Value of Old Machine (a) $300,000 Book Value of Old Machine (b) $200,000 Profit on Old Machine (c=a-b) $100,000 Tax on Profit (d = c*40%) $40,000 Post tax Salvage value of Old machine (a-d) $260,000Related Questions
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