8. Analysis of a replacement project

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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.

Price Co. is considering replacing an existing piece of equipment. The project involves the following:

	The new equipment will have a cost of $1,200,000, 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 $20,000 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 $700,000 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	selector 1 $1,200,000 $52,500 $525,000 $507,500
EBIT		selector 2 $700,000 $245,000 $52,500 $100,000	selector 3 $1,200,000 $245,000 $700,000 $52,500	selector 4 $700,000 $400,000 $245,000 $52,500	selector 5 $700,000 $500,000 $245,000 $52,500	selector 6 $700,000 $52,500 $150,000 $245,000	selector 7 $52,500 $245,000 $700,000 $150,000
Taxes		selector 8 $245,000 $20,000 $35,000 $700,000	selector 9 $20,000 $700,000 $35,000 $245,000	selector 10 $35,000 $20,000 $1,200,000 $245,000	selector 11 $245,000 $700,000 $20,000 $35,000	selector 12 $245,000 $1,200,000 $35,000 $20,000	selector 13 $35,000 $245,000 $20,000 $1,200,000
+ Depreciation T		selector 14 $52,500 35,000 245,000 20000 -$955,000	selector 15 525,000 35,000 245,000 20000 $52,500	selector 16 20000 245,000 35,000 507,500 $52,500	selector 17 52,500 35,000 525,000 245,000 20000	selector 18 245,000 70,000 20000 545,000 35,000	selector 19 20000 -$955,000 245,000 35,000 70,000
+ Salvage value	selector 20 $1,200,000 $700,000 $245,000 $300,000
Tax on salvage	selector 21 $300,000 $245,000 $52,500 $35,000
NWC	selector 22 $20,000 $-$955,000 $525,000 $300,000
+ Recapture of NWC							selector 23 $20,000 $35,000 -$955,000 $525,000
Total free cash flow	selector 24 -$955,000 $245,000 $700,000 $52,500	selector 25 $507,500 -$700,000 $245,000 $52,500	selector 26 $52,500 $507,500 -$700,000 $245,000	selector 27 $507,500 $245,000 $52,500 $700,000	selector 28 $245,000 -$700,000 $507,500 $52,500	selector 29 $245,000 -$700,000 $525,000 $52,500	selector 30 $245,000 $700,000 $545,000 $52,500

Points:

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

$1,321,520

$1,266,457

$1,101,267

$936,077