# 1. Morgan Nichols must estimate the NPV of a replacement decision ...

## Question

1. Morgan Nichols must estimate the NPV of a replacement decision for West Records. Incremental cost of new machinery will be \$7.639 million. The machinery will increase annual revenues by \$7.886 million and annual costs by \$5.294 million. Working capital needs will change too with inventories up by \$1.393 million, accounts receivable up by \$1.749 million and accounts payable up by \$1.116 million. The company uses a cost of capital of 9.0% and the tax rate is 48.0%. If the new equipment will last 7 years, what is the NPV of the replacement decision? Assume straight line depreciation. Why?

2. Katy Johnson, the finance officer of West Records, is preparing a recommendation for the following new project. Initial investment in plant and equipment \$7.895 million required today. Revenues from sales starting one year from now will be \$8.247 million per year. Costs starting one year from now will be \$4.879 million per year. If the project will last 7 years, what is its IRR? Assume the tax rate is 34.1% and straight line depreciation is used. Why?

3. Wang Corp is investigating a new project which requires an initial investment in plant and equipment of \$7.741 million. In addition, the project requires an investment of \$2.098 million toward working capital starting year 1. Of course, the working capital investment will be fully recovered during the last year of the project. The expectation is that the project will start yielding annual revenues starting one year from now of \$8.483 million. Annual costs are expected to be \$4.808 million. It is estimated that the appropriate discount rate is 8.7%, the tax rate is 41.1%. If the project will last 5 years, what is its NPV? Assume straight line depreciation. Why?

4. Jill Peck is considering the following new project in the auto parts business. Initial investment in plant and equipment \$9.094 million required today. Revenues from sales starting one year from now \$8.656 million per year. Costs starting one year from now \$3.876 million per year. If the project will last 8 years, what is its NPV? Assume the appropriate discount rate is 14.8%, the tax rate is 35.6% and straight line depreciation is used. Why?

5. Wendy Down must estimate the NPV of a replacement decision for Wyatt Earp. Incremental cost of new machinery will be \$8.220 million. The machinery will increase annual revenues by \$9.117 million and annual costs by \$4.782 million. Working capital needs will change too with inventories up by \$1.198 million, accounts receivable up by \$2.007 million and accounts payable up by \$1.167 million. The company uses a cost of capital of 8.6% and the tax rate is 41.1%. If the new equipment will last 9 years, what is the NPV of the replacement decision? Assume straight line depreciation. Why?

## Solution Preview

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The cash outflows associated with this project are:
• Incremental investment in machinery.
• Increase in working capital due to the new machinery.
The cash inflows associated with the project are:
• Annual operating cash flows (i.e. additional income from the project)
• Release of working capital at the end of the project.

In this case,
At Year 0 (i.e. now), we need to make investment in machinery = \$7.639
This is cash outflow.

The Increase in Working capital = Increase in inventories + Increase in accounts receivable – Increase...

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