I was going through reading 28. On page 36 there is an equation for replacement project written
Outlay = FCInv + NWCInv - Sal0 + T( SAL0 - B0)
For replacement project it makes sense that the outflow will be adjusted for the Salvage value of the equipment being sold now and the tax expense will be added in the outlay. But on Page 37 it states that at the project termination the new equipment will be sold at value more than the old (replaced) equipment that is why Incremental cash flows will be used. In calculation it has used Change in Salvage value.
I am confused that we already have adjusted the initial outlay for Salvage inflow of the original equipment then how come at termination the incremental cash flow of new equipment with old one is used? Aren’t we disposing the new equipment so only its salvage value should be used? In Equation it has not mentioned Change in Salvage Value at temination but in calculation it is using the change in salvage of new and expected value of old at project termination date.
Please look carefully at what got used for the Sal0 in the above equation. The current market value of 600K got used. The original equipment’s depreciated value of 100K never got used at all. That would be accounted for in the Salvage Value of the new equipment (200K - 100K) at the end of the new project’s life. Hope this answers your question.
Thanks CPK I got it regarding S0 but at the end of the project regarding 200K - 100K it is still confusing. I think as we only consider the effect of incremental cash flows and change in salvage value is the incremental cash flow that is why we are using it. Plus I might be looking at it with accounting perspective not with capital budgeting perspective.
you never considered the 100K Salvage value if you do not look at it from an incremental cash flow perspective then you might overstate / understate the cashflows on any project.
Well even looking at it with an accounting perspective, because the example is a replacement project, you assume that you are replacing the old equipment, hence why you also need to consider the expected salvage value of the old equipment (you assume you are selling it to replace it with the new machine).