6. Analysis of a replacement project

Consider the case of Price Company:

The managers of Price 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.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 $30,000 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 operating income before taxes will increase by a total of $400,000 in each of the next five years (years 15). (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 9%.The company's annual tax rate is 40%.

Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment.

Year 0Year 1Year 2Year 3Year 4Year 5Initial investment( ) Oper. inc. before tax $400,000Taxes ( )( )( )( )( )New depreciation Old depreciation ( )( )( ) Net salvage value Net working capital( ) Return of net working capital Total net cash flow( ) $2,040,000

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