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The new equipment will have a cost of $1,200,000, and it will be depreciated on a straight-line basis over a period of six years (years
The new equipment will have a cost of $1,200,000, and it will be depreciated on a straight-line basis over a period of six years (years 16). | |
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 $45,000 that will be recovered at the end of the project's life (year 6). | |
The new machine is more efficient, so the firms incremental earnings before interest and taxes (EBIT) will increase by a total of $400,000 in each of the next six years (years 16). 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 30%. |
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 | |||||||
EBIT | |||||||
Taxes | |||||||
+ Depreciation T | |||||||
+ Salvage value | |||||||
Tax on salvage | |||||||
NWC | |||||||
+ Recapture of NWC | |||||||
Total free cash flow |
The net present value (NPV) of this replacement project is:
A $433,397
B $270,873
C $361,164
D $415,339
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