A firm has decided to replace a major piece of industrial equipment. The equipment costs $690,000 to purchase and install and is expected to have a useful life of 5 years, after which it will be sold on the open market and is expected to have a salvage value of $200,000. The firm has a required return on equity of 14% and a large number of outstanding common shares held by many small investors. The firm is financed 50% with debt and 50% with equity.
The new equipment will be one of a large group of assets with a CCA rate of 20%. The firm will finance the purchase with a bank loan at the rate of 7% per year, the same interest rate it pays on its current debt. The loan will be repaid in equal instalments at the end of each year. The corporate tax rate is 40%. The company is responsible for maintenance and insurance costs of $40,000 per year. The new equipment will allow the firm to increase production, and sales will increase by $270,000 per year.
a) Calculate the NPV of the project using the APV method.
b) Calculate the project's return on equity, and use it to calculate the NPV of the project using the FTE method.
c) Explain which method you prefer in this case and why.