Chapter 11Web Extension:

Replacement Project Analysis

In Chapter 11, Regency Integrated Chips’ appliance control computer projectwas used to show how an expansion project is analyzed. All companies, includ-ing this one, also make replacement decisions, and the analysis relating toreplacements is somewhat different from that for expansion because the cashflows from the old asset must be considered. Replacement analysis is illustratedwith another RIC example, this time from the company’s research and devel-opment (R&D) division.

A lathe for trimming molded plastics was purchased 10 years ago at a costof $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 sal-vage value will be zero at the end of its 15-year life. The machine is being depre-ciated 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-yearlife, it will reduce labor and raw materials usage sufficiently to cut annual oper-ating costs from $9,000 to $4,000. This reduction in costs will cause before-taxprofits 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 fiveyears; this is its estimated salvage value. The old machine’s actual current mar-ket value is $1,000, which is below its $2,500 book value. If the new machineis acquired, the old lathe will be sold to another company rather thanexchanged for the new machine. The company’s marginal federal-plus-state taxrate is 40 percent, and the replacement project is of slightly below-average risk.Net operating working capital requirements will also increase by $1,000 at thetime of replacement. By an IRS ruling, the new machine falls into the 3-yearMACRS class, and, since the cash flows are relatively certain, the project’s costof capital is only 11.5 percent versus 12 percent for an average-risk project.Should the replacement be made?

Table 11E-1 shows the worksheet format the company uses to analyzereplacement projects. This spreadsheet is part of the spreadsheet model, FM11 Ch11 Tool Kit.xls developed for this chapter. Click on the “ReplacementAnalysis” tab at the bottom of the chapter model to view the replacementanalysis model. Input data are shown in Cells F11 through F18, and theMACRS 3-year depreciation schedule is given in the range of cells from A22through E24. Each spreadsheet row is numbered, and a row-by-row descriptionof the table follows.

See the FFMM1111 CChh 1111TTooooll KKiitt..xxllss for aspreadsheet solution.

FMe-resource

11E-2 Chapter 11 Web Extension: Replacement Project Analysis

Table 11E-1 Replacement Analysis Spreadsheet

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 Project’s 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

FECB G H IDA

Row 26 Rows 26, 27, and 28 show the net depreciation if the old lathe isreplaced.

Row 32 Section I shows the cash flows that occur at (approximately) t � 0, thetime 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 would be sold at less than book value, the salewould create a loss that would reduce the firm’s taxable income, and thus its nextquarterly 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 definesthis 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 thesale price had exceeded book value), Row 35 would have shown a tax liability, acash outflow. In the actual case, the equipment would be sold at a loss, so no taxeswould be paid, and the company would realize a tax savings of $600.1

Row 36 The investment in additional net operating working capital (new currentasset requirements minus increases in accounts payable and accruals) is shown here.This investment will be recovered at the end of the project’s life (see Row 51). Notaxes are involved.

Row 39 Section II of the table shows the incremental operating cash flows, orbenefits, that are expected if the replacement is made. The first of these benefits isthe reduction in operating costs shown on Row 40. Cash flows increase becauseoperating costs are reduced by $5,000. The net effect is that we can show the reduc-tion in costs as though it were incremental pre-tax operating profit (excludingdepreciation).

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 theincremental cash flows caused by replacing the machine versus not replacing it.

Row 42 After subtracting depreciation, we are left with incremental earningsbefore taxes.

Row 43 This is the incremental tax, based on the firm’s 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 operatingcash flows.

Row 48 Section III shows the cash flows associated with the termination of theproject. To begin, Row 49 shows the estimated salvage value of the new machine atthe end of its five-year life, $2,000.2

Chapter 11 Web Extension: Replacement Project Analysis 11E-3

1If the old asset were being exchanged for the new asset, rather than being sold to a third party, the tax consequenceswould be different. In an exchange of similar assets, no gain or loss is recognized. If the market value of the old assetis greater than its book value, the depreciable basis of the new asset is decreased by the excess amount. Conversely, ifthe market value of the old asset is less than its book value, the depreciable basis is increased by the shortfall.2In this analysis, the salvage value of the old machine is zero. However, if the old machine was expected to have a pos-itive salvage value at the end of five years, replacing the old machine now would eliminate this cash flow. Thus, theafter-tax salvage value of the old machine would represent an opportunity cost to the firm, and it would be includedas a Year 5 cash outflow in the terminal cash flow section of the worksheet.

Row 50 Since the book value of the new machine at the end of Year 5 is zero, thecompany 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 asan outflow at t � 0. This investment, like the new machine’s salvage value, will berecovered when the project is terminated at the end of Year 5. Accounts receivablewill be collected, inventories will be drawn down and not replaced, and the resultwill 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 budg-eting evaluation. In effect, Row 54 is a “time line.”

Section V of the table, “Capital Budgeting Analysis,” shows the replacement proj-ect’s NPV, IRR, MIRR, and payback. Because of the nature of the project, it is lessrisky than the firm’s average project, so a cost of capital of only 11.5 percent isappropriate. The NPV of the project is $3,991.08; therefore, the project is accept-able, hence the old lathe should be replaced.

11E-4 Chapter 11 Web Extension: Replacement Project Analysis