At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment. The company will need to do replacement analysis to determine which option is the best financial decision for the company.Price Co. is considering replacing an existing piece of equipment. The project involves the following:•The new equipment will have a cost of $9,000,000, and it is eligible for 100% bonus depreciation so it will be fully depreciated at t = 0.•The old machine was purchased before the new tax law, so it is 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 operating working capital (NOWC) of $20,000 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 $400,000 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 25%. Complete the following table and compute the incremental cash flows associated with the replacement of the old equipment with the new equipment.Year 0Year 1Year 2Year 3Year 4Year 5Initial-$6,750,000investmentEBIT- Тахes- ADepreciation+ SalvagevalueТах onsalvageNOWC+Recaptureof NOWCTotal freecash flow

Incremental cash flows refer to the expected increase or decline in the cash flows of the company which are linked to a new project or any sort of new investment in a new asset. Preparing the statement as follows: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial Investment $ 6,750,000 (9000000×(1-25%)) EBIT $ 400,000 $ 400,000 $ 400,000 $ 400,000 $ 400,000 $ 400,000 -Taxes (25 %) $ 100,000 $ 100,000 $ 100,000 $ 100,000 $ 100,000 $ 100,000 ( - ) Depreciation taxes $ 12,500 $ 12,500 $ 12,500 $ 12,500 Nil Nil - Salvage value $ 300,000 ( +) Tax on salvage $ 25,000 ( - ) NWC $ 20,000 + Recapture of NWC $ 20,000 Total free cash flow $(6,495,000) $ 2,87,500 $ 2,87,500 $ 2,87,500 $2,87,500 $ 300,000 280,000 Present Value of Cashflows @ 13 % 1.000 0.88450 0.78315 0.693050 0.61332 0.542760 0.48032 $(6,495,000) $254,293.75 $225,155.625 $199,251.86 $176,329.5 $162,828 $134,489.6 Net present value= ($5,694,419.322) Note; Tax on Salvage = (Sale value - Book Value) × Tax Rate = $50,000 × 25% = 12,500

Answered: = 0. • The old machine was purchased…

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment. The company will need to do replacement analysis to determine which option is the best financial decision for the company.

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

•	The new equipment will have a cost of $9,000,000, and it is eligible for 100% bonus depreciation so it will be fully depreciated at t = 0.
•	The old machine was purchased before the new tax law, so it is 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 operating working capital (NOWC) of $20,000 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 $400,000 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 25%.

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
Initial
-$6,750,000
investment
EBIT
- Тахes
- A
Depreciation
+ Salvage
value
Тах on
salvage
NOWC
+
Recapture
of NOWC
Total free
cash flow

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