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Net Investment Calculations

A firm is considering an investment of $28 million (purchase price) in new equipment to replace old equipment with a book value of $12 million and a market value of $20 million. If the firm replaces the old equipment with the new equipment, it expects to save $17.5 million in operating costs the first year.The amount of these savings will grow at a rate of 12 percent
per year for each of the following three years.The old equipment has a remaining life of four
years. It is being depreciated by the straight-line method. 33.3 percent of the original book
value of the new equipment will be depreciated in the first year, 39.9 percent will be depreciated in the second year, 14.8 percent will be depreciated in the third year, and 12.0 percent will be depreciated in the final year.The salvage value of both the old equipment and the new equipment at the end of four years is 0. In addition, replacement of the old equipment with the new equipment requires an immediate increase in net working capital of $5 million, which will not be recovered until the end of the four-year investment. Assume that the purchase and sale of equipment occurs today and all other cash flows occur at the end of their respective years. If the firm's cost of capital is 14 percent and is subject to a 40 percent tax rate, find:

a. The net investment.
b. The after-tax incremental cash flow at the end of each year.
c. The internal rate of return on the investment.
d. The net present value of the investment.

Solution Summary

A firm is considering an investment of $28 million (purchase price) in new equipment to replace old equipment with a book value of $12 million and a market value of $20 million. If the firm replaces the old equipment with the new equipment, it expects to save $17.5 million in operating costs the first year.The amount of these savings will grow at a rate of 12 percent

$2.19