EnterTech has noticed a significant decrease in the profitability of its line of
ID: 2537607 • 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.
c. If the manager of EnterTech is uncertain about the accuracy of the cost savings estimate, what actions could be taken to double-check the estimate?
New Machine 120,000 Cost of Investment 5 Years 34,000 Cash Savings - Salvage value at end of life 24,000Annual Depreciation
Explanation / Answer
Particulars Amount Savings in cost 34000 Incremental Depreciation (120000-100000)/5 -4000 Profit Before Tax 30000 Tax @ 40% 12000 Profit Before Tax 18000 Add:Depriciation 4000 Annual Cash Flow 22000 Cost of New Equipment 120000 Less: Replacement Value 20000 Less: Tax Savings 32000 Net Cost 68000 year Cash flow DF@12% PV 0 -68000 1 -68000 1 22000 0.893 19646 2 22000 0.797 17534 3 22000 0.712 15664 4 22000 0.636 13992 5 22000 0.567 12474 NPV 11310 The manager can use the probability theory to estimate the cost savings and can compute the net present value under the best and worst situation
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