14.3: Replacement Decisions

Question 1

What is the focus of cash flows in replacement decisions?

Answer 1

Replacement decisions focus on marginal or incremental cash flows that arise from the investment decision.

These are additional cash flows generated by replacing an existing asset with a new one.

Question 2

What are expansion projects?

Answer 2

Expansion projects add something extra to the firm in terms of sales or cost savings, generating new incremental cash flows.

Question 3

What are replacement projects?

Answer 3

Replacement projects involve replacing an existing asset with a new one, focusing on incremental cash flows resulting from this replacement.

Question 4

How do you estimate the incremental capital cost (ΔC₀) for replacement decisions?

Answer 4

ΔC₀ = C₀New - C₀Old

where C₀New is the purchase price of the new asset and C₀Old is the salvage price of the old asset.

Question 5

How is the initial after-tax cash outlay (ΔCF₀) calculated in replacement decisions?

Answer 5

ΔCF₀ = ΔC₀ + ΔNWC₀ + OC,

where ΔC₀ is the incremental capital cost,

ΔNWC₀ is the change in net working capital,

and OC is any opportunity cost.

Question 6

How do you estimate the present value of annual incremental operating cash flows (ΔOperating CFs)?

Answer 6

PV(ΔOperating CFs) = (ΔCFBT × (1 - T)) × [1 - (1 / (1 + k)ⁿ)] / k,

where ΔCFBT is the annual incremental cost savings,

T is the tax rate,

k is the discount rate,

and n is the project’s life.

Question 7

What is the formula for the present value of the incremental CCA tax shield (PV(ΔCCA Tax Shield))?

Answer 7

PV(ΔCCA Tax Shield) = [(ΔC₀)(d)(T) / (d + k)] × [1 - (1 / (1 + k)ⁿ)] - [(ΔSVₙ)(d)(T) / (d + k)] × [1 / (1 + k)ⁿ]

where d is the CCA rate and

ΔSVₙ is the incremental salvage value.

Question 8

How do you estimate the incremental ending cash flow (ΔECFₙ) in replacement decisions?

Answer 8

ΔECFₙ = ΔSVₙ + ΔNWCₙ,

where ΔSVₙ is the incremental salvage value and

ΔNWCₙ is the net working capital released.

Question 9

What is the formula for calculating the NPV of replacement decisions?

Answer 9

NPV = PV(ΔOperating CFs) + PV(ΔCCA Tax Shield) + PV(ΔECFₙ) - ΔCF₀,

where each term represents the present value of the respective incremental cash flows or costs.

Question 10

How does accelerated depreciation impact replacement decisions?

Answer 10

Accelerated depreciation increases the CCA rate in the acquisition year, altering the PV(ΔCCA Tax Shield) and potentially impacting the NPV of the replacement decision.