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.

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

The new equipment will have a cost of $$1,800,000,$ and it will be depreciated on a straight$-$line basis over a period

of six years $($years $1-6).$

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 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 $35\%.$

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 $1$

Initial

investment

EBIT

Taxes

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

$$438,541$

$$324,139$

$$381,340$

$$286,005$