Activity Frame

The new equipment will have a cost of $$600,000,$ and it is eligible for $100\%$ bonus

depreciation so it will be fully depreciated at $t=0.$

The old machine was purchased before the new tax law, so it is 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 $$30,000$ 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 $$600,000$ 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 $25\%.$

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 $5$

Initial

investment

EBIT

Taxes

$-$

Depreciation

$$ T

Salvage

value

Tax on

salvage

NOWC

$+$

Recapture

of NOWC

Total free

cash flow

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

$$1,885,351$

$$1,806,795$

$$1,571,126$

$$1,178,345$