The management of Devine Instrument Company is considering the purchase of a new

Question

The management of Devine Instrument Company is considering the purchase of a new drilling machine, model RoboDril 1010K. According to the specifications and testing results, RoboDril will substantially increase productivity over AccuDril X10, the machine Devine is currently using. The AccuDril was acquired 8 years ago for $110,000 and is being depreciated using the straight-line method over a 10-year expected life and an estimated salvage value of $10,000. The engineering departmet expects the AccuDril to keep going for another 3 years after a major overhaul at the end of its expected useful life. The estimated cost for the overhaul is $100,000. The overhauled machine will be depreciated using straight-line depreciation with no salvage value. The overhaul will improve the machine's operating efficiency approximately 20% for each of years 3. 4, and 5. No other operating conditions will be affected by the overhaul. RoboDril 1010K is selling for $220,000. Installing. testing. rearranging, and training will cost another $20,000. The manufacturer is willing to take the AccuDril as a trade-in for $30.000. The RoboDril will be depreciated using the straight-line method with no salvage value. New technology most likely will make RoboDril obsolete to the firm in 5 years Variable operating cost for either machine is the same: $8 per machine hour (cash-based). Other pertinent data follow Accuori1 Robobril 1818K 1e,ege 4,eee s100 xae 18,88e Units of output (per year) Machine hours Selling price per unit Variable ranufacturing cost-cash-based (not including machine hours) other annual expenses (tooling and supervising) Disposal value-today Disposal value-in 5 years S100 $3e $60,880 3e $9e,e86 $15,ee 35e,880 Devine Instrument Company's weighted-average cost of capital (WACC) is 12%, and it is in the 40% tax bracket. Use the PV factors (Append x C, Table d for calculating the NPV of each decision alternative

Explanation / Answer

1.

PV of net cash

outflows

After tax operating cost (1)

PV difference in cash flows between

alternatives

Notes:

1. Years 1 and 2 = $8 x 8000 hrs x (1-0.40) = $38,400

Years 3,4,5 = $8 x 8000 hrs (1-0.20)(1-0.40) = $30,720

2. Depreciation = 100,000-10000 / 10 = $10,000 per year

Tax savings 1st and 2nd year = 10,000 x 0.4 = $4,000

years 3-5 after overhauling ={( 100,000 + 10,000) / 3 ] x 0.40 = 14,667

Remark: Robodrill should be purchased instead of overhauling Accudrill

Particulars

PV of net cash

outflows

0 1 2 3 4 5 Overhaul/Accudrill:

After tax operating cost (1)

38,400 38,400 30,720 30,720 30,720 Overhaul cost 100,000 Tax savings on depreciation (2) (4,000) (4,000) (14,667) (14,667) (14,667) Other cash expenses after tax 54,000 54,000 54,000 54,000 54,000 After tax cash flows 88,400 188,400 70,053 70,053 70,053 Total PV @12% 363,301 Buy Robodrill 1010K: Net equipment purchase 240,000 after tax cash Op.cost 19,200 19,200 19,200 19,200 19,200 Tax savings on depreciation (16,800) (16,800) (16,800) (16,800) (16,800) Other cash expenses after tax 36,000 36,000 36,000 36,000 36,000 After tax salvage value (30,000) After tax cash flows 210,000 38,400 38,400 38,400 38,400 8,400 Total PV @12% 331,397

PV difference in cash flows between

alternatives

$31,904 in favor of Robodrill

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