Johnson Co. is considering replacing an existing piece of equipment. The project involves the following: • 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 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 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 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). 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 40%. 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 + Δ 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: $829,515 $975,900 $1,171,080 $731,925
Johnson Co. is considering replacing an existing piece of equipment. The project involves the following: • 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 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 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 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). 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 40%. 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 + Δ 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: $829,515 $975,900 $1,171,080 $731,925
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
Related questions
Question
Johnson Co. is considering replacing an existing piece of equipment. The project involves the following:
| • | The new equipment will have a cost of $1,200,000, and it will be |
| • | 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 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). 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 40%. |
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 | |||||||
| + Δ Depreciation × T | |||||||
| + Salvage value | |||||||
| – Tax on salvage | |||||||
| – NWC | |||||||
| + Recapture of NWC | |||||||
| Total |
The net present value (NPV) of this replacement project is:
$829,515
$975,900
$1,171,080
$731,925
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