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BA2802_chap009_Replacement Problem_studentversion

Course: FINANCE 257, Spring 2012
School: Boğaziçi University
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Word Count: 339

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11 Cash CHAPTER Flow Estimation and Evaluation for a Replacement Project 1 Replacement Project Example Required rate of return (Cost of Capital) = 11% Tax rate = 35% Original Machine Book value = 100,000 Resale value today = 80,000 Resale Value in 4 years = 20,000 Straight Line Depreciation over 2 years to a value of 0 New Machine Acquisition cost = 280,000 4-year life Resale value in 4 years =...

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11 Cash CHAPTER Flow Estimation and Evaluation for a Replacement Project 1 Replacement Project Example Required rate of return (Cost of Capital) = 11% Tax rate = 35% Original Machine Book value = 100,000 Resale value today = 80,000 Resale Value in 4 years = 20,000 Straight Line Depreciation over 2 years to a value of 0 New Machine Acquisition cost = 280,000 4-year life Resale value in 4 years = 50,000 Straight Line Depreciation over 4 years to a value of 0 Cost savings = 80,000 per year Additional Investment in NWC at time 0 = 40,000 2 Replacement Problem Computing Cash Flows Remember that we are interested in incremental cash flows, i.e. CF for New Machine CF for Old Machine If we buy the new machine, then we will sell the old machine at time 0 What are the cash flow consequences of selling the old machine today instead of in year 4? 3 Replacement Problem Incremental Depreciation Expense Year 1 2 3 4 Depreciation on New 70,000 70,000 70,000 70,000 Depreciation on Old 50,000 50,000 0 0 Change in Depreciation 20,000 20,000 70,000 70,000 4 Replacement Problem Pro Forma Income Statement Year 1 2 3 4 Change in Revenue 0 0 0 0 Change in Cost -80,000 -80,000 -80,000 -80,000 Change in Depreciation 20,000 20,000 70,000 70,000 EBIT 60,000 60,000 10,000 10,000 Taxes 21,000 21,000 3,500 3,500 EBIT(1-T) 39,000 39,500 6,500 6,500 Depreciation 20,000 20,000 70,000 70,000 Net Problem OCF 59,000 59,000 76,500 76,500 5 Replacement Incremental Net Capital Spending Year 0 Cost of new machine = \$280,000 (outflow) After-tax proceeds from sale of old machine = \$80,000 - 0.35(80,000 100,000) = \$87,000 (inflow) Additional Investment in NWC = \$40,000 (outflow) Incremental net capital spending = -280,000 40,000 + 87,000 = -\$233,000 6 Replacement Problem Incremental Net Capital Spending Year 4 7 Replacement Problem Cash Flows Year 0 1 2 3 4 59,000 Initial Investment 59,000 76,500 76,500 59,000 59,000 76,500 -280,000 Net OCF Net Proceeds from selling machines 87,000 in NWC -40,000 Net CFAT -233,000 8 Replacement Problem Analyzing the Cash Flows Now that we have the cash flows, we can compute the NPV, PI, IRR, MIRR and Payback Period NPV = ? PI = ? IRR = ? MIRR = ? Payback Period = ? Should the company replace the equipment? 9 Replacement Problem Analyzing the Cash Flows Now that we have the cash flows, we can compute the NPV, IRR, MIRR, PI, Payback Period and Discounted Payback Period NPV = \$13,562 > 0, Accept the project, i.e. replace the machine. PI = 1.0582 > 1, Accept the project, i.e. replace the machine. IRR = 13.33% > 11%, Accept the project, i.e. replace the machine. MIRR = 12.58% > 11%, Accept the project, i.e. replace the machine. Payback Period = 3.28 > 3, Reject the project, i.e. do not replace the machine. 10
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