Question

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 is eligible for 100% bonus depreciation so it will be fully depreciated at t = 0.
•	The old machine was purchased before the new tax law, so it is 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 operating working capital (NOWC) 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 $700,000 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 25%.

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
– Δ Depreciation × T
+ Salvage value
– Tax on salvage
– NOWC
+ Recapture of NOWC
Total free cash flow

The net present value (NPV) of this replacement project is:

$963,147

$818,675

$1,107,619

$722,360

Answer 1