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Consider the case of LoRusso Company: The managers of LoRusso Company are considering replacing an existing piece of equipment, and have collected the following information:
Consider the case of LoRusso Company:
The managers of LoRusso 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 $9,000,000, and it will be depreciated on a straight-line basis over a period of five years. | |
The old machine is also being depreciated on a straight-line basis. It has a book value of $200,000 (at year 0) 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 $20,000 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 operating income before taxes will increase by a total of $300,000 in each of the next five years (years 15). (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 required rate of return is 11%. | |
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 | |
---|---|---|---|---|---|---|
Initial investment | ( ) | |||||
Oper. inc. before tax | $300,000 | |||||
Taxes | ( ) | ( ) | ( ) | ( ) | ( ) | |
New depreciation | ||||||
Old depreciation | ( ) | ( ) | ( ) | |||
Net salvage value | ||||||
Net working capital | ( ) | |||||
Return of net working capital | ||||||
Total net cash flow | ( ) | $1,995,000 |
The net present value (NPV) of this replacement project is
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