4. Analysis of a replacement project

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

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

•	The new equipment will have a cost of $2,400,000, and it iseligible for 100% bonus depreciation so it will be fullydepreciated at t = 0.
•	The old machine was purchased before the new tax law, so it isbeing 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 ofthe 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 netoperating working capital (NOWC) of $20,000 that will be recoveredat the end of the project's life (year 6).
•	The new machine is more efficient, so the firm’s incrementalearnings before interest and taxes (EBIT) will increase by a totalof $400,000 in each of the next six years (years 1–6). Hint: Thisvalue represents the difference between the revenues and operatingcosts (including depreciation expense) generated using the newequipment 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 cashflows associated with the replacement of the old equipment with thenew 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
– NOWC
+ Recapture of NOWC
Total free cash flow

The net present value (NPV) of this replacement project is:

-$373,310

-$429,306

-$317,314

-$279,982