The Gilbert Instrument Corporation is considering replacing the wood steamer it currently uses to shape guitar sides. The steamer has 6 years of remaining life. If kept, the steamer will have depreciation expenses of $650 for 5 years and $325 for the sixth year. Its current book value is $3,575, and it can be sold on an Internet auction site for $4,150 at this time. If the old steamer is not replaced, it can be sold for $800 at the end of its useful life.
Gilbert is considering purchasing the Side Steamer 3000, a higher-end steamer, which costs $12,000, and has an estimated useful life of 6 years with an estimated salvage value of $1,200. This steamer falls into the MACRS 5-years class, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. The new steamer is faster and would allow for an output expansion, so sales would rise by $2,000 per year; even so, the new machine’s much greater efficiency would reduce operating expenses by $1,600 per year. To support the greater sales, the new machine would require that inventories increase by $2,900, but accounts payable would simultaneously increase by $700. Gilbert’s marginal federal-plus-state tax rate is 40%, and its WACC is 13%.
The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below.
Open spreadsheet
Should it replace the old steamer?
The old steamer _________shouldshould not be replaced.
What is the NPV of the project? Do not round intermediate calculations. Round your answer to the nearest dollar.
$ fill in the blank 3
Old Equipment: | ||||||||||||||||||||||||||||||||||||||||||||
Depreciation expense, Years 1 to 5 | $ | 6 | ||||||||||||||||||||||||||||||||||||||||||
Depreciation expense, | Year 6 | $325 | ||||||||||||||||||||||||||||||||||||||||||
Current book value | $3,575 | |||||||||||||||||||||||||||||||||||||||||||
Current market value | $4,150 | |||||||||||||||||||||||||||||||||||||||||||
Market value, Year 6 | $800 | |||||||||||||||||||||||||||||||||||||||||||
New Equipment: | ||||||||||||||||||||||||||||||||||||||||||||
Estimated useful life (in years) | ||||||||||||||||||||||||||||||||||||||||||||
Purchase price | $12,000 | |||||||||||||||||||||||||||||||||||||||||||
Salvage value, Year 6 | $1,200 | |||||||||||||||||||||||||||||||||||||||||||
Annual sales increase | $2,000 | |||||||||||||||||||||||||||||||||||||||||||
Annual reduction in operating expenses | $1,600 | |||||||||||||||||||||||||||||||||||||||||||
Initial increase in inventories | $2,900 | |||||||||||||||||||||||||||||||||||||||||||
Initial increase in accounts payable | $700 | |||||||||||||||||||||||||||||||||||||||||||
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | ||||||||||||||||||||||||||||||||||||||||
MACRS depreciation rates (5-year class): | 20.00% | 32.00% | 19.20% | 11.52% | 5.76% | |||||||||||||||||||||||||||||||||||||||
Tax rate | 40.00% | |||||||||||||||||||||||||||||||||||||||||||
WACC | 13.00% | |||||||||||||||||||||||||||||||||||||||||||
Step 1: Calculation of investment at t = 0 | ||||||||||||||||||||||||||||||||||||||||||||
Formulas | ||||||||||||||||||||||||||||||||||||||||||||
Purchase price of new equipment | ($12,000) | |||||||||||||||||||||||||||||||||||||||||||
Sale of old equipment | ||||||||||||||||||||||||||||||||||||||||||||
Tax on sale of old equipment | ERROR:#N/A | |||||||||||||||||||||||||||||||||||||||||||
Change in net operating working capital | ||||||||||||||||||||||||||||||||||||||||||||
Total investment outlay | ||||||||||||||||||||||||||||||||||||||||||||
Step 2: Calculation of annual after-tax cash inflows | ||||||||||||||||||||||||||||||||||||||||||||
Annual increase in pre-tax revenues | ||||||||||||||||||||||||||||||||||||||||||||
After-tax annual revenue increase | ||||||||||||||||||||||||||||||||||||||||||||
Step 3: Calculation of annual depreciation tax savings | ||||||||||||||||||||||||||||||||||||||||||||
New equipment | ||||||||||||||||||||||||||||||||||||||||||||
Old equipment | $650 | |||||||||||||||||||||||||||||||||||||||||||
Change in annual depreciation | ($650) | ($325) | ||||||||||||||||||||||||||||||||||||||||||
Annual dpreciation tax savings | ||||||||||||||||||||||||||||||||||||||||||||
Annual depreciation tax savings | ||||||||||||||||||||||||||||||||||||||||||||
Step 4: Calculation of net present value of replacement | ||||||||||||||||||||||||||||||||||||||||||||
Year 0 | ||||||||||||||||||||||||||||||||||||||||||||
Initial investment outlay | $0 | |||||||||||||||||||||||||||||||||||||||||||
Annual after-tax revenue increase | ||||||||||||||||||||||||||||||||||||||||||||
Working capital recovery | ||||||||||||||||||||||||||||||||||||||||||||
Salvage value on new equipment | ||||||||||||||||||||||||||||||||||||||||||||
Tax on salvage value of new equipment | ||||||||||||||||||||||||||||||||||||||||||||
Opportunity cost of old equpment | ||||||||||||||||||||||||||||||||||||||||||||
Project cash flows | #N/A | |||||||||||||||||||||||||||||||||||||||||||
Net present value | ||||||||||||||||||||||||||||||||||||||||||||
Should firm replace the old equipment? |
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