8. 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.

The company will need to do replacement analysis to determine which option is the best financial decision for the company.

LoRusso 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 16).
	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 $45,000 that will be recovered at the end of the project's life (year 6).
	The new machine is more efficient, so the firms incremental earnings before interest and taxes (EBIT) will increase by a total of $500,000 in each of the next six years (years 16). 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 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	_____
EBIT		_____	_____	____	____	___	___
Taxes		____	_____	_____	____	_____	____
+ Depreciation T		____	_____	______	_____	_____	____
+ Salvage value	____
Tax on salvage	____
NWC	____
+ Recapture of NWC
Total free cash flow	_____	______	______	_______	______	______	_____

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

-$6,495,026

-$4,600,644

-$5,412,522

-$6,224,400