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 share 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 $1,500. This steamer falls into the MACRS 5-yr 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?

show your calculation please

Explanation / Answer

Step 1: Calculate Annual Cash Flow:

Cash Flow (Year 0) = -Initial Investment + Value Realized from Replacement of Old Steamer - Increase in Working Capital - Tax on Sale of Old Machine = -12,000 + 4,150 - (2,900 - 700) - (4,150 - 3,575)*40% = -$10,280

__________

Cash Flow Year 1 to 6

Notes:

1) Net Loss of Revenue on old steamer would be $480 (800 - 800*40%)

2) Working capital of $2,200 would get recovered in the final year.

3) Since, the new steamer will get fully depreciated by year 6, the entire salvage value will be reported as gain ($1,500) and tax ($1,500*40%) on the same will get deducted.

___________

Step 2: Calculate NPV:

NPV can be calculated with the use of following formula:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+WACC)^1 + Cash Flow Year 2/(1+WACC)^2 + Cash Flow Year 3/(1+WACC)^3 + Cash Flow Year 4/(1+WACC)^4 + Cash Flow Year 5/(1+WACC)^5 + Cash Flow Year 6/(1+WACC)^6

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NPV = -10,280 + 3,040/(1+15%)^1 + + 3,616/(1+15%)^2 + 3,002/(1+15%)^3 + 2,633/(1+15%)^4 + 2,633/(1+15%)^5 + 5,106/(1+15%)^6 = $2,093.51

Since, the new steamer generates a positive NPV, old steamer should be replaced.

1 2 3 4 5 6 Increase in Sales 2,000 2,000 2,000 2,000 2,000 2,000 Savings in Costs 1,900 1,900 1,900 1,900 1,900 1,900 Total Benefits 3,900 3,900 3,900 3,900 3,900 3,900 Less Taxes 1,560 1,560 1,560 1,560 1,560 1,560 After Tax Benefits (A) 2,340 2,340 2,340 2,340 2,340 2,340 Depreciation on New Steamer 2,400 3,840 2,304 1,382 1,382 691 Depreciation on Old 650 650 650 650 650 325 Change 1,750 3,190 1,654 732 732 366 Tax Savings on Depreciation (B) 700 1,276 662 293 293 146 Total Savings (A+B) 3,040 3,616 3,002 2,633 2,633 2,486 Recovery of Working Capital 0 0 0 0 0 2,200 Salvage Value of New Steamer 0 0 0 0 0 1,500 Less Tax on Salvage Value 0 0 0 0 0 -600 Less Net Loss of Revenue (Old Steamer) 0 0 0 0 0 -480 Net Annual Cash Flows $3,040 $3,616 $3,002 $2,633 $2,633 $5,106

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