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 $1,200,000, 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 O) 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 $400,000 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 the new equipment and that earned using the old equipment. ) The project's required rate of return is 13%. The company's annual tax rate is 35%. Year o Year 1 Year 2 Year 3 Year 4 Year 5 Initial investment EBIT $400,000 Less: Taxes Plus: New depreciation Less: Old depreciation Plus: Salvage value Less: Tax on salvage Less: NWC Plus: Recapture of NWC Total Net $500,000 Cash Flow The net present value (NPV) of this replacement project is 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 $1,200,000, 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 O) 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 $400,000 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 the new equipment and that earned using the old equipment. ) The project's required rate of return is 13%. The company's annual tax rate is 35%. Year o Year 1 Year 2 Year 3 Year 4 Year 5 Initial investment EBIT $400,000 Less: Taxes Plus: New depreciation Less: Old depreciation Plus: Salvage value Less: Tax on salvage Less: NWC Plus: Recapture of NWC Total Net $500,000 Cash Flow The net present value (NPV) of this replacement project is
