Question
Lo Co. is considering replacing an existing piece of equipment. The project involves the following: -New equipment will haVe a cost of $2,400,000 and it
Lo Co. is considering replacing an existing piece of equipment. The project involves the following: -New equipment will haVe a cost of $2,400,000 and it will be depreciated on a straight-line basis over a period of 6 years (years 1-6) -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). -New equipment will have a salvage value of $0 at the end of the project's life (year 6). Old machine has a current salvage (at year 0) of $300,000. -Replacing the old machine will require an investment in net working capital (NWC) of $60,000 that will be recovered at the end of the project's life (year 6) -New machine is more efficient, so the firms incremental earnings before interest and taxes (EBIT) wil decrease by total of $400,000 in each of the next six year (years 1-6). Hint:This value represents the difference between the revenues ad operating costs (including depreciation expense) generated using the new equipment and that earned using the old equipment. -Projects cost of capital is 13% Company annual tax rate is 40%
1.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 | NA | NA | NA | NA | NA | NA | |
| EBIT | $400,000 | ||||||
| (-) Taxes | |||||||
| (+) New depreciation | |||||||
| (-) Old depreciation | |||||||
| (+)Salvage value | NA | NA | NA | NA | NA | NA | |
| (-) Tax on salvage | NA | NA | NA | NA | NA | NA | |
| (-) NWC | NA | NA | NA | NA | NA | NA | |
(+) Recapture of NWC | NA | NA | NA | NA | NA | NA | |
| Total free cash flow | $640,000 |
|
2. The net present value (NPV) of this replacement project is
a. $274,306
b. $238,527
c. $202,748
d. $286,232
The conventional payback period ignores the time value of money, and this concerns Cold Goose CFO. He has now asked you to compute Beta's discounted payback period, assuming the company has a 8% cost of capital. Complete the following table and perform any necessary calculations. Round the discounted cash flow values to the nearest whole dollar, and discounted payback period to the nearest two decimal places.
3.Complete entire table
| Year 0 | Year 1 | Year 2 | Year 3 | |
| Cash Flow | -5,000,000 | $2,000,000 | $4,500,000 | $1,750,000 |
| Discounted cash flow | ||||
| Cumulative discounted cash flow | ||||
| Discounted payback period | NA | NA | NA- |
4.Which version of a projected payback period should the CFO use when evaluating Project Beta, given its theoretical superiority?
a. Regular payback period
b. discounted payback period
One theoretical disadvantage of both payback methods-compared to the net present value method-is that they fail to consider the value of the cash flows beyond the point in time equal to the payback period.
5.How much value does the discounted payback period method fall to recognize due to this theoretical deficiency?
a. $3,241,058
b. $5,032,896
c. $1,884,748
d. $1,389,206
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Precalculus
Authors: Michael Sullivan
9th edition
321716835, 321716833, 978-0321716835
