Chapter 12 Cash Flow Estimation and Risk Analysis 373Data applicable to both machines:
Sales revenues, which would remain constant $2,500
Expected life of the new and old machines 4 years
WACC for the analysis 10%
Tax rate 40%
Data for old machine:
Market (salvage) value of the old machine today $400
Old labor, materials, and other costs per year $1,000
Old machine’s annual depreciation $100
Data for new machine:
Cost of new machine $2,000
New labor, materials, and other costs per year $400
The key here is to " nd the incremental cash! ows. As noted previously, we " nd
the cash! ows from the operation with the old machine, then " nd the cash! ows
with the new machine, then " nd the differences in the cash! ows. This is what we
do in Parts I, II, and III of Table 12-2. Since there will be an additional expenditure
to buy the new machine, that cost is shown in Cell E13. However, we can sell the
old machine for $400, so that is shown as an in! ow in Cell E14. The net cash outlay
at Time 0 is $1,600, as shown in Cell E23.
The net cash! ows based on the old machine are shown on Row 11 and those
for the new machine are on Row 23. Then on Row 25, we show the differences in
the cash! ows with and without replacement—these are the incremental cash
! ows used to " nd the NPV. When we evaluate the incremental cash! ows, we see
that the replacement has an NPV of $80.28, so the old machine should be
replaced.^3
In some instances, replacements add capacity as well as lower operating
costs. When this is the case, sales revenues in Part II would be increased; and if
that led to a need for more working capital, that number 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 re! ected in the differential cash! ows on
Row 25.
(^3) We could have found the incremental cash " ows by calculating the di# erences in the only factors that change,
the net cost of the new machine, operating cost savings reduced for the taxes, and the di# erences in deprecia-
tion, which save some taxes. This procedure is shown in the lower section of the table. The two procedures pro-
duce the same incremental cash " ows and NPV, as they must.
SEL
F^ TEST What role do incremental cash! ows play in a replacement analysis?
If you were analyzing a replacement project and you suddenly learned that
the old equipment could be sold for $1,000 rather than $100, would this
new information make the replacement look better or worse? (Better; the
net initial investment would be lower.)
In Table 12-2, we assumed that output would not change if the old machine
was replaced. Suppose output would actually double. How would this
change be dealt with in the framework of Table 12-2?