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At times firms will need to decide if they want to continue touse their current equipment or replace the equipment with newerequipment. In this case, the company will need to perform areplacement analysis to determine which alternative is the bestfinancial decision for the company.

Consider the case of Price Company

: The managers of Price Company are considering replacing anexisting piece of equipment, and have collected the followinginformation:

• The new piece of equipment will have a cost of $9,000,000, andit will be depreciated on a straight-line basis over a period offive years (years 1–5).

• The old machine is also being depreciated on a straight-linebasis. It has a book value of $200,000 (at year 0) and three moreyears of depreciation left ($50,000 per year).

• The new equipment will have a salvage value of $0 at the endof the project's life (year 5). The old machine has a currentsalvage value (at year 0) of $300,000.

• Replacing the old machine will require an investment in networking capital (NWC) of $60,000 that will be recovered at the endof the project's life (year 5).

• The new machine is more efficient, so the incremental increasein earnings before interest and taxes (EBIT) will increase by atotal of $600,000 in each of the next five years (years 1–5).(Hint: This value represents the difference between the revenuesand operating costs (including depreciation expense) generatedusing the new equipment and that earned using the old equipment.)

• The project's required rate of return is 8%.

• The company's annual tax rate is 30%
.

PT I

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Initial Investment	$2,280,000/$9,000,000/$1,800,000/$600,000
EBIT		$100,000/$1,800,000/$9,000,000/$600,000	$9,000,000/$600,000/$100,000/$1,800,000	$600,000/$100,000/$1,800,000/$9,000,000	$9,000,000/$600,000/$100,000/$1,800,000	$600,000
Less: Taxes		180,000/1,800,000/60,000/9,000,000	1,800,000/9,000,000/180,000/60,000	1,800,000/60,000/180,000/9,000,000	1,800,000/60,000/180,000/9,000,000	1,800,000/60,000/180,000/9,000,000
Plus: New Depreciation		30,000/1,800,000/-60,000/180,000	180,000/-60,000/1,800,000/30,000	1,800,000/-60,000/180,000/30,000	1,800,000/-60,000/30,000/180,000	30,000/1,800,000/-60,000/180,000
Less: Old Depreciation		300,000/50,000/180,000/-60,000	50,000/300,000/-60,000/180,000	180,000/-60,000/50,000/300,000
Plus: Salvage Value	1,800,000/180,000/300,000/2,280,000
Less: Tax on Salvage	300,000/1,800,000/180,000/30,000
Less: NWC	2,280,000/1,800,000/300,000/60,000
Plus: Recapture of NWC						-8,790,000/60,000/30,000/2,280,000
Total Net Cash Flow	$-8,790,000/$1,800,000/$180,000/$9,000,000	$9,000,000/$1,800,000/$2,170,000/$600,00	$9,000,000/$600,000/$1,800,000/$2,170,000	$2,170,000/$1,800,000/$9,000,000/$180,000	$2,220,000	$9,000,000/$1,800,000/$600,000/$2,280,000

************ BOLDED NUMBERS ARE THE CHOICES PER BOX**************

PART II

The net present value (NPV) of this replacement project is$12,073/$-16,335/$-14,204/$-10,653