CashFlow Estimation

Replacement Projects
Replacement analysis
For replacement projects we must find the cash flow differentials
between the new and old projects, and these differentials are the
incremental cash flows that we must analyze.
Identify the incremental cash flows.
In some instances, replacements add capacity as well as lower
operating costs. In this case, sales revenues would be increased,
and if that leads to a need for more working capital, then this
would be shown as a Time-0 expenditure along with a recovery at
the end of the project’s life. These changes would, of course, be
reflected in the incremental cash flows.
Consider an example of replacing an old machines with a new highly
efficient machine.
We start:
1. Identify the inputs including deprecation on new & old machines.
2. Find out the cash flows the firm will have if it continues to use the old
machine.
3. Find the cash flows if the firm replaces the old machine.
4. Subtract the old flows from the new to arrive at the incremental cash
flows,
5. Evaluate those flows in above to find the NPV, IRR, and MIRR, to decide
if replacing the old machine appears to be a good decision or not.
Illustration on replacement analysis
Net cashflow of old machine
Net cashflow of new machine
Part 4 & 5: Incremental CF & NPV
0 yr 1 yr 2 yr 3 yr 4 yr

New CF (1600) $1,599 $1,688 $1,450 $1,391

Less: Old CF $0 $914 $913 $780 $780

(1600) $685 $774 $670 $611

Part 5: Evaluation NPV = $584.02

11-7
Before tax operating cost = 25000
After tax operating cost=25000 (1-T)
= 25000 (1-0.4)= $15000

Depreciation shield = Depreciation (T)

Depreciation=
yr. 1= 85000 * 0.33= $28050 *0.4= 11220
Yr 2= 85000* 0.45 = $ 38250 *0.4= 15300
Yr 3 = 85000* 0.15 = $12750 * 0.4= 5100
11-7 part c & d
11-4

Cash outflow = $40,000.

Increase in annual after-tax cash flows: CF = $9,000
WACC is 10%,
NPV=?
NPV= initial cost – PVA
= [(40000) – 55301.10]
= $15,301.10.

Yes chen Company Should buy new machine.

11-9
• Initial investment in replacement with new machine at t = 0:
• Purchase price ($8,000)
• Less: Sale of old machine 2,500
• Investment required for New machine= 5500
• Tax on sale of old machine (2500-2100=400*0.4)=(160)
• Change in net working capital = (2000-500) =
(1,500)
• Total investment ($7,160)
Annual cash inflows
Now, examine the annual cash inflows:
• Revenue increase through Sales = $1,000
• Cost decrease = +1,500
• Increase in pre-tax revenues= $2,500
• After-tax revenue increase:
$2,500(1 – T) = $2,500(0.60) = $1,500.
Depreciation change & Depreciation tax savings

Depreciation tax savings = T(Depreciation) = 0.4(Depreciation)

Problem 11-10
Pre depreciation earning from New machinery Minus earnings from old
Machine=54000 – 27000 = 27000
After-tax revenue increase:
$27,000(1 – T) = $27,000(0.60) = $16,200
Depreciation tax savings = T(Depreciation) = 0.4(Depreciation)
*

*Annual CF= After tax

earnings+ depreciation tax
saving)
NPV = $22,329.39.
11-13
Homework
• 11-13
• 11-14