EnterTech has noticed a significant decrease in the profitability of its line of
ID: 2537603 • Letter: E
Question
EnterTech has noticed a significant decrease in the profitability of its line of portable CD players. The production manager believes that the source of the trouble is old, inefficient equipment used to manufacture the product. The issue raised, therefore, is whether EnterTech should (1) buy new equipment at a cost of $120,000 or (2) continue using its present equipment.
It is unlikely that demand for these portable CD players will extend beyond a five-year time horizon. EnterTech estimates that both the new equipment and the present equipment will have a remaining useful life of five years and no salvage value.
The new equipment is expected to produce annual cash savings in manufacturing costs of $34,000, before taking into consideration depreciation and taxes. However, management does not believe that the use of new equipment will have any effect on sales volume. Thus, its decision rests entirely on the magnitude of the potential cost savings.
The old equipment has a book value of $100,000. However, it can be sold for only $20,000 if it is replaced. EnterTech has an average tax rate of 40 percent and uses straight-line depreciation for tax purposes. The company requires a minimum return of 12 percent on all investments in plant assets.
Annual Depreciation
a. Compute the net present value of the new machine using the tables in Exhibits 26–3 and 26–4.
b. What nonfinancial factors should EnterTech consider?
New Machine 120,000 Cost of Investment 5 Years 34,000 Cash Savings - Salvage value at end of life 24,000Annual Depreciation
Explanation / Answer
a. Net Present Value of the new machine replaces
B. Following nonfinancial factors EnterTech should consider
1. Whether the existing employees are capable to handle the new machine?
2. Whether exactly same quality of product is manufactured from the new machine?
3. Is there any impact on the selling price of the product?
Calculation of cash flows: Amount Net increase in Depreciation New Machine Depreciation 24,000 Old Machine Depreciation 20,000 Increase in depreciation expences 4,000 Incremental increase in annual income Cash savings of new machine 34,000 Less: Increase in depreciation (4,000) Increase in pretax income 30,000 Income tax rate 40% Increase in income taxes Expences 12,000 Incremental increase in annual cash flow Cash savings of new machine 34,000 Less: Increase in income taxes (12,000) Increase in annual cash flow 22,000 Tax savings on loss of old machine sale Book value of old machine 100,000 Proceeds from sale (20,000) Loss on sale of disposal 80,000 Income tax rate 40% Tax savings 32,000Related Questions
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