The Gilbert Instrument Corporation is considering replacing the wood steamer it

Question

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 five 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 $1,500. This steamer falls into the MACRS 5-year 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 allows for an output expansion, so sales would rise by $2,000 per year; the new machine’s much greater efficiency would reduce operating expenses by $1,900 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 15%. Should it replace the old steamer?

Explanation / Answer

The Gilbert Instrument Corporation All Amounts in $ In case the old steamer is not replaced Costs per year net of Tax = $ 650 X 60% = $ 390 Costs in the last year = $ 325 X 60% = $ 195 Sale Value at the end of the useful life = $ 800 Thus, using the WACC of 15%, the Net Present Value of the old steamer will be $ 39.43 If the old steamer is replaced with a new steamer Book Value of Steamer for written down purposes = (12,000 - 1,500) = $ 10,500 Depreciation per year as per 5-Year MACRS Year Depn Rate Depreciation Depn. Post tax 1 20% 2100 1260 2 32% 3360 2016 3 19.20% 2016 1209.6 4 11.52% 1209.6 725.76 5 11.52% 1209.6 725.76 6 5.76% 604.8 362.88 Increase in Cash Inflows per year (Increase in Sales + Reduction in Operating Expenses) X Post Tax Rate = ($ 2,000 + $ 1,900) X 60% = 2340 $ per year Net Operating Income per year post tax Year Operating Income 1 1080 2 324 3 1130.4 4 1614.24 5 1614.24 6 1977.12 Increase in Working Capital in Year 0 = $ 2,900 - $ 700 = $ 2,200 With this information, and the WACC as 15%, the Net Present Value of the steamer works out to -$ 7,510.18 Since the Net Present Value of the new steamer is negative, hence the replacement should not be done.

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