3. Analysis of a replacement project At times firms will need to decide if they

Question

3. 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 Johnson 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 (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 $D 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 $20,000 that will be recovered at the end of the project's life (year . 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). 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 35%. Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial investment EBIT - Taxes + New depreciation $600,000 Old depreciation +Salvage value Tax on salvage -NWC +Recapture of NWC Total free cash flow $790,000 The net present value (NPV) of this replacement project is: O $863,947 O $1,036,736 O $647,960 $734,355

Explanation / Answer

Statement showing NPV

WN 1) Salvage value

Thus NPV = $863947

Particulars 0 1 2 3 4 5 6 NPV(sum of all PV) Initial invetsment 2400000 NW requirement 20000 Salvage value -265000 Total initial investment 2155000 EBIT 600000 600000 600000 600000 600000 600000 Tax @ 35% 210000 210000 210000 210000 210000 210000 PAT 390000 390000 390000 390000 390000 390000 Add: New depreciation(2400000/6) 400000 400000 400000 400000 400000 400000 Less: old depreciation 50000 50000 50000 50000 Annaul cash flow 740000 740000 740000 740000 790000 790000 Release of WC 20000 Total cash flow -2155000 740000 740000 740000 740000 790000 810000 PVIF @ 13% 1 0.885 0.783 0.693 0.613 0.543 0.480 PV -2155000 654867.3 579528.5 512857.1 453855.9 428780.3 389058 863947

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