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13

C H A P T E R
13E-1
Web Extension: Replacement Project Analysis
In Chapter 13, Regency Integrated Chips appliance control computer project was used to
show how an expansion project is analyzed. All companies, including this one, also make
replacement decisions, and the analysis relating to replacements is somewhat different from
that for expansion because the cash flows from the old asset must be considered. Replace-
ment analysis is illustrated with another RIC example, this time from the companys research
and development (R&D) division.
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A lathe for trimming molded plastics was purchased 10 years ago at a cost of
$7,500. The machine had an expected life of 15 years at the time it was pur-
chased, and management originally estimated, and still believes, that the salvage
value will be zero at the end of its 15-year life. The machine is being depreciated
on a straight-line basis; therefore, its annual depreciation charge is $500, and its
present book value is $2,500.
The R&D manager reports that a new special-purpose machine can be pur-
chased for $12,000 (including freight and installation), and, over its five-year life,
it will reduce labor and raw materials usage sufficiently to cut annual operating
costs from $9,000 to $4,000. This reduction in costs will cause before-tax profits
to rise by $9,000 $4,000 $5,000 per year.
It is estimated that the new machine can be sold for $2,000 at the end of five
years; this is its estimated salvage value. The old machines actual current market
value is $1,000, which is below its $2,500 book value. If the new machine is
acquired, the old lathe will be sold to another company rather than exchanged for
the new machine. The companys marginal federal-plus-state tax rate is 40 percent,
and the replacement project is of slightly below-average risk. Net operating working
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13E-2 Chapter 13 Web Extension: Replacement Project Analysis
capital requirements will also increase by $1,000 at the time of replacement. By an
IRS ruling, the new machine falls into the 3-year MACRS class, and, since the cash
flows are relatively certain, the projects cost of capital is only 11.5 percent versus 12
percent for an average-risk project. Should the replacement be made?
Table 13E-1 shows the worksheet format the company uses to analyze replace-
ment projects. This spreadsheet is part of the spreadsheet model, IFM9 Ch13 Tool
Kit.xls developed for this chapter. Click on the Replacement Analysis tab at the
bottom of the chapter model to view the replacement analysis model. Input data
are shown in Cells F11 through F18, and the MACRS 3-year depreciation schedule
is given in the range of cells from A22 through E24. Each spreadsheet row is
numbered, and a row-by-row description of the table follows.
Row 26 Rows 26, 27, and 28 show the net depreciation if the old lathe is
replaced.
Row 32 Section I shows the cash flows that occur at (approximately) t 0, the
time the investment is made. Row 33 shows the purchase price of the new machine,
including installation and freight charges. Since it is an outflow, it is negative.
Row 34 Here we show the price received from the sale of the old equipment.
Row 35 Since the old equipment will be sold at less than book value, the sale
will create a loss that will reduce the firms taxable income, and thus its next
quarterly income tax payment. The tax saving is equal to (Loss)(T) ($1,500)
(0.40) $600, where T is the marginal corporate tax rate. The Tax Code defines
this loss as an operating loss, because it reflects the fact that inadequate deprecia-
tion was taken on the old asset. If there had been a profit on the sale (that is, if
the sale price had exceeded book value), Row 35 would have shown a tax liabil-
ity, a cash outflow. In the actual case, the equipment will be sold at a loss, so no
taxes will be paid, and the company will realize a tax savings of $600.
1
Row 36 The investment in additional net operating working capital (new cur-
rent asset requirements minus increases in accounts payable and accruals) is
shown here. This investment will be recovered at the end of the projects life (see
Row 51). No taxes are involved.
Row 39 Section II of the table shows the incremental operating cash flows, or
benefits, that are expected if the replacement is made. The first of these benefits is
the reduction in operating costs shown on Row 40. Cash flows increase because
operating costs are reduced by $5,000. The net effect is that we can show the
reduction in costs as though it were incremental pre-tax operating profit (exclud-
ing depreciation).
Row 41 Just as in the analysis of an expansion, we subtract depreciation. How-
ever, we subtract only the net change in depreciation, since we are estimating the
incremental cash flows caused by replacing the machine versus not replacing it.
1
If the old asset were being exchanged for the new asset, rather than being sold to a third party, the tax consequences
would be different. In an exchange of similar assets, no gain or loss is recognized. If the market value of the old asset is
greater than its book value, the depreciable basis of the new asset is decreased by the excess amount. Conversely, if the
market value of the old asset is less than its book value, the depreciable basis is increased by the shortfall.
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Chapter 13 Web Extension: Replacement Project Analysis 13E-3
Replacement Analysis Spreadsheet Tabl e 13E- 1
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
Input Data
Cost of the new machine
Reduction in operating costs
New machine's salvage value at end of Year 5
Old machine's current market value
Old machine's current book value
Increase in Net Operating WC
Tax rate
WACC
MACRS 3-year Depreciation Schedule
Year
Depr. Rate
Depr. Exp.
New depr.
Old depr.
Net depr.
Replacement Project Net Cash Flow Schedule
Section I. Investment Outlay
Cost of new equipment
Market value of old equipment
Tax savings on old equipment sale
Increase in net operating WC
Section II. Operating Inflow over the Projects Life
Decrease in operating costs
Net change in depreciation
Net earnings before taxes
Taxes
Net operating profit after taxes
Add back depreciation
Net operating cash flows
Section III. Terminal Year Cash Flows
Estimated salvage value of new machine
Tax on salvage value (40%)
Return of net operating WC
Total termination cash flows
Section IV. Net Cash Flow
Cumulative cash flows (for payback)
Section V. Capital Budgeting Analysis
Net Present Value (11.5%)
IRR
MIRR
Payback (in years)
$12,000
$5,000
$2,000
$1,000
$2,500
$1,000
40%
11.5%
1
33%
$3,960
$3,960
$500
$3,460
2
45%
$5,400
$5,400
$500
$4,900
3
15%
$1,800
Year 0
($12,000)
1,000
600
(1,000)
$5,000
3,460
1,540
616
924
3,460
$4,384
$5,000
4,900
100
40
60
4,900
$4,960
$5,000
1,300
3,700
1,480
2,220
1,300
$3,520
$5,000
340
4,660
1,864
2,796
340
$3,136
$5,000
(500)
5,500
2,200
3,300
(500)
$2,800
$2,000
(800)
1,000
$2,200
($11,400)
($11,400)
$3,991.08
25.03%
18.40%
2.58
$4,384
($7,016)
FALSE
$4,960
($2,056)
FALSE
$3,520
$1,464
2.58
$3,136
$4,600
3.47
$5,000
$9,600
4.92
1 2 3 4 5
$1,800
$500
$1,300
4
7%
$840
$840
$500
$340
0
$500
$500
F E C B G H I D A
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13E-4 Chapter 13 Web Extension: Replacement Project Analysis
Row 42 After subtracting depreciation, we are left with incremental earnings
before taxes.
Row 43 This is the incremental tax, based on the firms 40 percent tax rate.
Row 44 After subtracting taxes, we are left with the incremental after-tax oper-
ating profit.
Row 45 Since depreciation is a noncash expense, we add it back.
Row 46 After adding back depreciation, we have the incremental net operating
cash flows.
Row 48 Section III shows the cash flows associated with the termination of the
project. To begin, Row 49 shows the estimated salvage value of the new machine
at the end of its five-year life, $2,000.
2
Row 50 Since the book value of the new machine at the end of Year 5 is zero,
the company will have to pay taxes of $2,000(0.4) $800.
Row 51 An investment of $1,000 in net operating working capital was shown
as an outflow at t 0. This investment, like the new machines salvage value, will
be recovered when the project is terminated at the end of Year 5. Accounts receiv-
able will be collected, inventories will be drawn down and not replaced, and the
result will be an inflow of $1,000 at t 5.
Row 52 Here we show the total cash flows resulting from terminating the project.
Row 54 Section IV shows the total cash flows in a form suitable for capital
budgeting evaluation. In effect, Row 54 is a time line.
Section V of the table, Capital Budgeting Analysis, shows the replacement proj-
ects NPV, IRR, MIRR, and payback. Because of the nature of the project, it is less
risky than the firms average project, so a cost of capital of only 11.5 percent is
appropriate. The NPV of the project is $3,991.08; therefore, the project is accept-
able; hence the old lathe should be replaced.
2
In this analysis, the salvage value of the old machine is zero. However, if the old machine was expected to have a posi-
tive salvage value at the end of five years, replacing the old machine now would eliminate this cash flow. Thus, the after-
tax salvage value of the old machine would represent an opportunity cost to the firm, and it would be included as a Year
5 cash outflow in the terminal cash flow section of the worksheet.
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