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

The new equipment will have a cost of $2,400,000, 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 $50,000 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 40%.

Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment.

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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Initial investment ______

EBIT ______ ______ _____ _____ ______ 600,000

- Taxes ______ ______ _____ _____ _______ _______

+ New depreciation ______ ______ _____ _____ _______ _______

- Old depreciation _______ _______ _____ _____

+ Salvage value _______

- Tax on salvage _______

- NWC _______

+ Recapture of NWC _______

Total free cash flow ______ ______ ______ _____ _____ $760,000 _______

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

$614,916

$868,116

$723,430 $831,945

CHOICE OF ANSWERS:

Initial Investment Year 0: 2,400,000 or 400,000 or 600,000 or 700,000

+ Salvage Value Year 0: 600,000 or 300,000 or 400,000 or 240,000

- Tax on Salvage Year 0: 40,000, 240,000 or 400,000 or 300,000

- NWC Year 0: 300,000 or 760,000 or 400,000 or 50,000

Total free cash flow Year 0: 240,000 or -2,190,000 or 2,400,000 or 400,000