Replacement Analysis The Gilbert Instrument Corporation is considering replacing
ID: 2646689 • Letter: R
Question
Replacement Analysis
The Gilbert Instrument Corporation is considering replacing the wood steamer it currently uses to shape guitar sides. The steamer, purchased just 2 years ago, is being depreciated on a straight-line basis and has 6 years of remaining life. Its current book value is $2,400, and it can be sold on an Internet auction site for $4,500 at this time. Thus, the annual depreciation expense is $2,400/6=$400 per year. 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 $8,000, and has an estimated useful life of 6 years with an estimated salvage value of $800. This steamer falls into the MACRS 5-years 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 would allow for an output expansion, so sales would rise by $2,000 per year; even so, the new machine's much greater efficiency would reduce operating expenses by $1,500 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 12%. Should it replace the old steamer?
yes or no?
What is the NPV of the project? Round your answer to the nearest dollar.
Explanation / Answer
Present Value on Replacement of Machinery > 0, hence it is financially viable to replace the old steamer
Notes:
1. Investment in New Machine = 8000
Sale of Old Machine = 4500 - Tax @ 40% = 2700
Net Change in Investment = 8000 - 2700 = 5300
2. Sale of new machinery at the end of 6 years = 800 - Tax @ 40% = $480
3. Net Increase in Revenue = (Increase in Sales + Decrease in Expenses) * (1 - Tax Rate)
= 3500 * 60%
= 2100
4. Change in Depreciation
Year Asset Changes in Working Capital Increase in Revenue Tax Savings @ 40% on Increase in Depreciation Net Change in Cashflow PV @ 12% Present Value 0 -5300 -2200 -5300 1 -5300 1 2100 480 2580 0.892857143 2303.571429 2 2100 864 2964 0.797193878 2362.882653 3 2100 454.4 2554.4 0.711780248 1818.171465 4 2100 208.64 2308.64 0.635518078 1467.182457 5 2100 208.64 2308.64 0.567426856 1309.984336 6 480 2200 2100 24.32 2604.32 0.506631121 1319.429562 Present Value on Replacement of Machinery 5281.221901