At times firms will need to decide if they want to continue to use their current equipment or replace the equipment with newer equipment. Thecompany will need to do replacement analysis to determine which option is the best financial decision for the company.LoRusso 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 att = 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 salvagevalue (at year 0) of $300,000.• Replacing the old machine will require an investment in net operating working capital (NOWC) of $60,000 that will be recovered at theend 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$300,000 in each of the next six years (years 1-6). Hint: This value represents the difference between the revenues and operatingcosts (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%. InitialinvestmentEBIT- Taxes- ADepreciationx T+ Salvagevalue- Tax onsalvage- NOWC+Recaptureof NOWCTotal freecash flow11Year 0-$5,643,913The net present value (NPV) of this replacement project is:O-$4,232,935O-$6,772,696O-$4,797,326Year 1Year 2Year 3Year 4Year 5

NPV of replacement is the difference in present value of cash flow from replacement minus new additional investment in equipments.Initial investment=cost of new equipment(1-tax)-book value of old equipment-(1-tax)(selling price-book value)+working capitalInitial investment=9000000(1-0.25)-200000-(1-0.25)(300000-200000)+60000=$6535000Initial investment year 0=-$6535000Cash flow year (1-4)=(1-tax)(EBIT)-depreciation old equipment x taxCash flow year (1-4)=(1-0.25)(300000)-50000 x 0.25=$212500Cash flow year (1-4)=$212500Cash flow year 5 =(1-0.25)(300000)=$225000Cash flow year 5=$225000Cash flow year 6=(1-tax)(EBIT)+working capitalCash flow year 6=(1-0.25)(300000)+60000=$285000Cash flow year 6=$285000NPV of replacement=$5643913Option 1 is correct

Answered: At times firms will need to decide if…

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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