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Homework answers / question archive / At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment
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 $600,000, 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 operating working capital (NOWC) of $50,000 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 $300,000 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 30%.
Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment. Year o Year 1 Year 2 Year 3 Year 4 Year 5 Year Initial $600,000 investment EBIT $300,1 Taxes + New depreciation - Old depreciation + Salvage value - Tax on salvage - NOWC + Recapture of NOWC Total free $310,000 cash flow
The net present value (NPV) of this replacement project is: $881,440. $734,533. Ο Ο Ο Ο $550,900. $624,353.
| New Equipment cost | $ 600,000 |
| Annual SL depreciation over 6 years = | $ 100,000 |
| Old Equipment Annual depreciation for remaining each of 4 years | $ 50,000 |
| Old Equipment current Book Value | $ 200,000 |
| Old Equipment Curreny salvage value | $ 300,000 |
| Capital gain on salvage | $ 100,000 |
| Tax Rate =30% | |
| Tax on Salvage Capital Gain = | $ 30,000 |
| Investment in NWC in Year 0= | $ 50,000 |
| Incremental Annual EBIT = | $ 300,000 |
| Cost of Capital | 13% |
| Free Cash flow and NPV | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
| Initial Investment | ||||||||
| New Equipment | $ (600,000) | |||||||
| Add : Salvage value of Old Equipment | $ 300,000 | |||||||
| Less: Tax on Capital gain of Salvage value | $ (30,000) | |||||||
| Investment in NOWC | $ (50,000) | |||||||
| a | Net Initial Investment | $ (380,000) | ||||||
| Operating Cash flow | ||||||||
| Incremental EBIT | $ 300,000.00 | $ 300,000.00 | $ 300,000.00 | $ 300,000.00 | $ 300,000.00 | $ 300,000.00 | ||
| Less : Tax @30% | $ (90,000.00) | $ (90,000.00) | $ (90,000.00) | $ (90,000.00) | $ (90,000.00) | $ (90,000.00) | ||
| Add Back : New Depreciation | $ 100,000 | $ 100,000 | $ 100,000 | $ 100,000 | $ 100,000 | $ 100,000 | ||
| Less: Old Depreciation(year 1 to4) | $ (50,000) | $ (50,000.00) | $ (50,000.00) | $ (50,000.00) | ||||
| b | Total Cash flow from Operations | $ 260,000.00 | $ 260,000.00 | $ 260,000.00 | $ 260,000.00 | $ 310,000.00 | $ 310,000.00 | |
| Terminal Cash flow | ||||||||
| c | Recapture of NOWC | $ 50,000 | ||||||
| d | Total Incremental Free Cash fow from Replacement Project=a+b+c= | $ (380,000) | $ 260,000 | $ 260,000 | $ 260,000 | $ 260,000 | $ 310,000 | $ 360,000 |
| e | PV Factor @13%=1/1.13^n= | 1.0000 | 0.8850 | 0.7831 | 0.6931 | 0.6133 | 0.5428 | 0.4803 |
| f | PV of Incremental FCF =d*e= | $ (380,000) | $ 230,088 | $ 203,618 | $ 180,193 | $ 159,463 | $ 168,256 | $ 172,915 |
| g | NPV =Sum of PV of Incremental FCF=Sum (f)= | $ 734,533 |
| So NPV of Replacement is $734,533 |
| Correct option is $734,533 |
