Question

7. 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. In this case, the company will need to perform a replacement analysis to determine which alternative is the best financial decision for the company.

Consider the case of Johnson Company:

The managers of Johnson Company are considering replacing an existing piece of equipment, and have collected the following information:

•	The new piece of equipment will have a cost of $9,000,000, and it will be depreciated on a straight-line basis over a period of five years (years 1–5).
•	The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at year 0) and three 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 5). 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 $45,000 that will be recovered at the end of the project's life (year 5).
•	The new machine is more efficient, so the incremental increase in earnings before interest and taxes (EBIT) will increase by a total of $600,000 in each of the next five years (years 1–5). (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 required rate of return is 12%.
•	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.

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Initial investment	________
EBIT		________	________	________	________	$600,000
Less: Taxes		________	________	________	________	________
Plus: New depreciation		________	________	________	________	________
Less: Old depreciation		________	________	________
Plus: Salvage value	________
Less: Tax on salvage	________
Less: NWC	________
Plus: Recapture of NWC						________
Total Net Cash Flow	________	________	________	________	$2,220,000	________

The net present value (NPV) of this replacement project is_________ .

Answer 1