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 $9,000,000, 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 $20,000 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 35%.

Complete the following table by selecting the correct answers 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	selector 1    $9,000,000 $700,000 $962,500 $507,500
EBIT		selector 2    $9,000,000 $700,000 $245,000 $100,000	selector 3    $700,000 $200,000 $9,000,000 $245,000	selector 4    $700,000 $400,000 $9,000,000 $245,000	selector 5    $245,000 $700,000 $507,500 $9,000,000	selector 6    $9,000,000 $150,000 $245,000 $700,000	selector 7    $9,000,000 $150,000 $700,000 $245,000
– Taxes		selector 8    $9,000,000 $35,000 $507,500 $245,000	selector 9    $507,500 $35,000 $9,000,000 $245,000	selector 10    $700,000 $35,000 $507,500 $245,000	selector 11    $35,000 $9,000,000 $507,500 $245,000	selector 12    $700,000 $507,500 $35,000 $245,000	selector 13    $700,000 $507,500 $245,000 $35,000
+ Δ Depreciation × T		selector 14    -$8,755,000 –20000 $507,500 35,000 245,000	selector 15    35,000 245,000 980,000 $507,500 –20000	selector 16    –20000 245,000 35,000 962,500 $507,500	selector 17    980,000 507,500 –20000 245,000 35,000	selector 18    245,000 1,000,000 –20000 35,000 525,000	selector 19    -$8,755,000 525,000 35,000 –20000 245,000
+ Salvage value	selector 20    507,500 $700,000 $980,000 $300,000
– Tax on salvage	selector 21    $35,000 $300,000 $507,500 $245,000
– NWC	selector 22    $980,000 $507,500 $20,000 $35,000
+ Recapture of NWC							selector 23    $20,000 $35,000 -$8,755,000 $980,000
Total free cash flow	selector 24    $700,000 -$8,755,000 $9,000,000 $507,500	selector 25    $9,000,000 $507,500 $962,500 $245,000	selector 26    $962,500 $507,500 $9,000,000 -$700,000	selector 27    $245,000 $507,500 $962,500 $9,000,000	selector 28    $9,000,000 $507,500 $962,500 -$700,000	selector 29    $9,000,000 $507,500 $980,000 -$700,000	selector 30    $1,000,000 $9,000,000 $507,500 $245,000

Points:

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

-$4,879,848

-$3,659,886

-$4,147,871

-$5,855,818

Answer 1

Year	0	1	2	3	4	5	6
Initial Investment	9000000
EBIT		700000	700000	700000	700000	700000	700000
Less: Taxes		245000	245000	245000	245000	245000	245000
Dep*Taxes		507500	507500	507500	507500	525000	525000
Salvage value	300000
Less: Tax on salvage	35000
Net working capital	20000
Recapture of NWC							20000
Total free cash flow	-8755000	962500	962500	962500	962500	980000	1000000
PVF	1	0.885	0.7831	0.6931	0.6133	0.5428	0.48032
PV of cash flows	-8755000	851770	753779	667061	590319	531905	480319
NPV	-4879848.1