Replacement Decision with Unequal Lives and a Deferral Option
Ridgeline Manufacturing is comparing two mutually exclusive investments. Project A upgrades the existing press: cost $8.0 million, 5-year life, pre-tax operating savings $2.6 million per year, salvage $1.0 million. Project B installs a new automated line: cost $15.0 million, 8-year life, pre-tax savings $3.4 million per year, salvage $2.5 million, and requires $1.5 million of additional net working capital, recovered at the end of year 8. Project B would cannibalize $0.4 million per year of pre-tax contribution from existing products. Both are depreciated straight-line to zero for tax purposes over their lives. The tax rate is 25% and the after-tax discount rate is 10%. The company has a $20 million capital budget but only $16 million of available cash this year, and the board is also considering deferring B for two years until demand is clearer. The CFO wants to choose B because it has the higher undiscounted total savings.
1. Compute NPV and equivalent annual annuity (EAA) for each project and recommend which project to choose. Show all workings.
Read the worked answer
Project A.
- Depreciation: $8.0M ÷ 5 = $1.6M
- Annual EBIT: $2.6M − $1.6M = $1.0M
- Tax: $0.25M; net income: $0.75M
- Operating cash flow: $0.75M + $1.6M = $2.35M
- PV of OCF: $2.35M × 3.7908 = $8.908M
- After-tax salvage: $1.0M × (1 − 25%) = $0.75M; PV: $0.75M × 0.6209 = $0.466M
- NPV: $8.908M + $0.466M − $8.0M = $1.374M
- EAA: $1.374M ÷ 3.7908 = $0.362M per year
Project B.
- Depreciation: $15.0M ÷ 8 = $1.875M
- Net pre-tax savings: $3.4M − $0.4M cannibalization = $3.0M
- EBIT: $3.0M − $1.875M = $1.125M
- Tax: $0.281M; net income: $0.844M
- Operating cash flow: $0.844M + $1.875M = $2.719M
- PV of OCF: $2.719M × 5.3349 = $14.504M
- After-tax salvage: $2.5M × 0.75 = $1.875M; PV: $1.875M × 0.4665 = $0.875M
- Working capital: −$1.5M at t0; PV of recovery: $1.5M × 0.4665 = $0.700M; net cost $0.800M
- NPV: −$15.0M + $14.504M + $0.875M − $0.800M = −$0.421M
- EAA: −$0.421M ÷ 5.3349 = −$0.079M per year
Recommendation: Choose Project A. It has a positive NPV and positive EAA, while B destroys value at the forecast savings. The CFO's comparison of undiscounted total savings is invalid because it ignores timing, the 8-year life, cannibalization, and the working capital investment. EAA confirms that A is the better use of capital even though B has a longer life.
2. At what annual pre-tax operating savings would Project B break even on an NPV basis? Interpret the sensitivity.
Read the worked answer
Set NPV to zero and solve for the required operating cash flow.
Required PV of OCF:
- Initial cost: $15.0M
- Net working capital cost: $0.800M
- PV of after-tax salvage: $0.875M
- Required PV of OCF = $15.0M + $0.800M − $0.875M = $14.925M
- Required annual OCF = $14.925M ÷ 5.3349 = $2.798M
Solve for pre-tax savings S:
OCF = (S − $0.4M cannibalization − $1.875M depreciation) × (1 − 0.25) + $1.875M = $2.798M
(S − $2.275M) × 0.75 = $0.923M
S − $2.275M = $1.230M
S = $3.505M
Project B breaks even at about $3.51M of annual pre-tax savings, versus the $3.40M forecast. The margin is only about 3.1%. Given that the savings estimate is uncertain and that cannibalization may be higher than $0.4M, B is not robust. A sensitivity table should also test lower cannibalization, higher salvage, and a delay in realizing savings. If the company can credibly identify at least $3.51M of savings, B becomes viable; otherwise A is preferred.
3. How should the deferral option and strategic factors affect the recommendation? What additional analysis would you require?
Read the worked answer
The deferral option has value because it allows Ridgeline to avoid an irreversible negative-NPV investment while preserving the chance to invest if demand improves. A two-year deferral is a real option: if demand rises enough that B's savings exceed $3.51M, the company can invest then; if not, it can walk away. That asymmetry can make "defer" preferable to "invest now" even when the current NPV is slightly negative. However, the option is not free: deferring may lose two years of savings, competitors may move, and the $15M cost may rise. The analysis should use a decision tree or scenario valuation, not a single point estimate.
Additional analysis required:
- Probability-weighted demand scenarios and the savings threshold at which B becomes positive.
- Whether Project A can be deferred or repeated; if A is chosen now, the company may forgo B's option value.
- The capital constraint: B requires $16.5M including working capital, leaving almost no buffer against the $16M cash limit; A requires $8M and preserves flexibility.
- Operating risks: disruption during installation, learning curve, maintenance, and obsolescence of the existing press.
- Strategic fit: whether the automated line creates a platform for future products that A cannot provide.
- Tax and salvage assumptions, including whether the CCA/tax depreciation treatment changes the result.
Recommendation: Proceed with A now if the press must be replaced. Do not commit to B on the current numbers. Set a stage gate: monitor demand and savings for 12–18 months, and exercise the deferral option only if the expected savings exceed the $3.51M break-even with a reasonable margin.