Finance, capital budgeting, homework help

Ferrell Products, Inc. (FPI) is negotiating for the purchase of a new piece of equipment for its current
operations. FPI has a bid which specifies that the equipment could be purchased for $150,000.

Other information about the project includes the following: The new equipment will replace existing
equipment that has a current market (i.e., resale) value of $20,000. If the new equipment is purchased,
the old equipment will be sold. The old equipment was purchased for $60,000 and is being depreciated
on a straight-line basis over ten years. It is expected to last another five years and to have no resale
value at the end of its life. It is currently five years old.

The new equipment is expected to have a positive effect on revenue. Revenues are expected to
increase by $20,000 per year in years 1 and 2, and to increase by $30,000 in years 3, 4, and 5. Before-
tax operating costs will also increase, however, by $5,000 per year in each year.

The increased sales will give rise to an aggregate increase in accounts receivable, inventory, and cash
equal to 30% of the increase in sales. The increase in current asset occurs at the beginning of each year,
or, effectively, at the end of the prior year. The initial increase in receivables, inventory, and cash will
occur at time 0 (i.e., they are needed to get the project started). This investment in working capital will
be recovered at the end of the project’s life.

The new equipment will be depreciated to zero using straight-line depreciation over five years. FPI
expects to discontinue this project, and sell the equipment for $25,000 in year five. The gain from the
proceeds of the sale is subject to the ordinary income tax rate of 35%.

The after-tax nominal cost of capital for this project is 10% per year.
What is the NPV of replacing the old machine with the new one?
ANSWER: _____________________

What should the company do? __________________________________________________

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