Assess Capital Budgeting Problems – Replacement Project

Background information: The capital budgeting process includes both expansionary type problems and replacement problems. In this activity, we consider a replacement problem. In a replacement problem, we are interested in evaluating whether a new machine/asset offers enough benefits in terms of future cash flows to justify the capital expenditure. The key to completing this type of analysis is the concept of incremental. This means we want to think in terms of subtracting the old cash flows on the existing machine from the net cash flows on the new machine. Commonly, in this type of a problem, we will assume that the impact on sales revenue is zero and that the analysis comes down to weighing the costs of the new machine against the expense reduction offered by the new machine. For each machine, we again develop the free cash flows as follows: Free Cash Flows = [EBIT(1-tax rate) + Depreciation and Amortization] - [Additional capital expenditures – additional net working capital] The EBIT is defined as sales fewer variables, expenses less fixed expenses, less depreciation. We form the FCFs for each machine for each year into the future, and then the difference these future FCFs make to generate the incremental cash flows.