The company will need to do replacement analysis to determine which option is th
ID: 2751172 • Letter: T
Question
The company will need to do replacement analysis to determine which option is the best financial decision for the company. Jones 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). 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 $60,000 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 $700,000 in each of the next six years (years 1-6).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. The net present value (NPV) of this replacement project is: $718,565 $1,149,703 $958,086 $814,373Explanation / Answer
Answer:
therefore, Net Present Value = ($ 681,415 + $ 630,018 + $ 533,648 + $ 472,255 + $ 445,062 + $ 422,680) - $ 2,520,000 = $ $ 3,158,079 - $ 2,520,000 = $ 638,078
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial Investment $ 2,400,000 Incremental EBIT $ 700,000 $ 700,000 $ 700,000 $ 700,000 $ 700,000 $ 700,000 Less: Tax@40% $ 280,000 $ 280,000 $ 280,000 $ 280,000 $ 280,000 $ 280,000 Add: New Depreciation $ 400,000 $ 400,000 $ 400,000 $ 400,000 $ 400,000 $ 400,000 Less: Old Depreciation $ 50,000 $ 50,000 $ 50,000 $ 50,000 NIL NIL Add: Salvage Value at year 0 $ 300,000 NIL NIL NIL NIL NIL NIL Less: Tax on Salvage Value $ 120,000 NIL NIL NIL NIL NIL NIL Less: Working Capital Requirement $ 60,000 NIL NIL NIL NIL NIL NIL Add: Working Capital Recovered NIL NIL NIL NIL NIL NIL $ 60,000 Total Free Cash Flow $ 2,520,000 $ 770,000 $ 770,000 $ 770,000 $ 770,000 $ 820,000 $ 880,000 Present Value factor @ 13% 1 0.884955 0.78314 0.693050 0.613318 0.542759 0.480318 Present value of cash flows $ 2,520,000 $ 681,415 $ 630,018 $ 533,648 $ 472,255 $ 445,062 $ 422,680