Rappach & McBride Company, Inc. (R&M) is negotiating to purchase a new piece of equipment for its current operations. R&M has received an offer which specifies that the new equipment can be purchased for $70,000.

Other information about the project includes the following: The new equipment will replace existing equipment that has a current market (i.e., resale) value of $20,000. If the new equipment is purchased, the old equipment will be sold. The old equipment was purchased for $40,000 and is being depreciated on a straight-line basis over ten years even though the equipment is expected to last another eight years. The old equipment is expected to have no resale value at the end of eight years. The equipment is currently five years old (i.e., the equipment has five remaining years of depreciation).

The new equipment is expected to have a positive effect on revenue. Revenues are expected to increase by $2,000 per year the first year, and to increase at the rate of inflation thereafter. Additionally, before-tax operating costs will be reduced by $10,000 per year in the first year, an amount that will increase at the rate of inflation, thereafter, for eight years. The revenues and cost savings will occur at year-end.

The increased sales will necessitate an aggregate increase in accounts receivable, inventory and cash equal to 25% of the increase in sales. That is, an increase in inventory, accounts receivable and cash will be required to support the higher level of sales. The increase in current asset occurs at the beginning of each year. Additionally, trade credit (i.e., accounts payable) will increase by an amount equal to 10% of the increase in sales. The increase in accounts payable occurs at the beginning of each year. The initial increase in receivables, inventory, cash and payables will occur at time 0 (i.e., these are needed to get the project started). This investment in net working capital will be recovered at the end of the projects life.

The new equipment will be depreciated to zero using MACRS depreciation over seven years. (Please see the MACRS table in your case packet.) R&M expects to discontinue this project and sell the equipment for $5,000 at the end of eight years. The gain from the proceeds of the sale of equipment is subject to the ordinary income tax rate of 34 percent.

The expected inflation rate is 3 percent per year. The after-tax nominal cost of capital for this project is 12 percent per year.

What is the NPV of replacing the old machine with the new one?

Hint: Remember to consider all incremental cash flows associated with the replacement.

(Note: This is an example of the classic replacement decision that confronts every company with extensive fixed assets such as an airline or a taxi company.)