Replacement Analysis The Gilbert Instrument Corporation is considering replacing
ID: 2768808 • 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 $2,100, and it can be sold on an Internet auction site for $4,500 at this time. Thus, the annual depreciation expense is $2,100/6=$350 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 15%. Should it replace the old steamer?
What is the NPV of the project? Round your answer to the nearest dollar.
$
Explanation / Answer
Depreciation Expense:
Year
Basis
%
Depreciation Expense
Actual Depreciation
1
$8,000.00
20.000%
$1,600.00
$1,250.00
2
$8,000.00
32.000%
$2,560.00
$2,210.00
3
$8,000.00
19.200%
$1,536.00
$1,186.00
4
$8,000.00
11.520%
$921.60
$571.60
5
$8,000.00
11.520%
$921.60
$571.60
6
$8,000.00
5.760%
$460.80
$110.80
Actual Depreciation = Depreciation of new machine – Foregone depreciation of old machine
Initial Investment:
Initial Investment:
Cost of New Machine
$8,000.00
Less: After tax Value of Old Machine
$3,540.00
Add: Increase in Working Capital
$2,200.00
Total
$6,660.00
After-tax value of Old Machine = $4,500 – [($4,500 - $2,100) x 40%] = $3,540
Increase in working capital = Additional Inventory – Increase in Accounts Payable = $2,900 - $700 = $2,200
Cash Inflow:
From year 1 to 5:
Rise in sales
$ 2,000.00
Add: Reduction in Operating Exp.
$ 1,500.00
Less: Depreciation
$ 1,250.00
EBT
$ 2,250.00
Less: Tax @ 40%
$ 900.00
Net Income
$ 1,350.00
Add: Depreciation
$ 1,250.00
Operating Cash Flow
$ 2,600.00
Year 6 => $2,600 + Salvage value of machine + Recovery of Working Capital
=> $2,600 + $800 + $2,200 = $5,600
NPV of the project:
= -$6,660 + [($2,600)/(1.15)] + [($2,600)/(1.15)2] + [($2,600)/(1.15)3] + [($2,600)/(1.15)4] + [($2,600)/(1.15)5] + [($5,600)/(1.15)6] = $4,536.64
Year
Basis
%
Depreciation Expense
Actual Depreciation
1
$8,000.00
20.000%
$1,600.00
$1,250.00
2
$8,000.00
32.000%
$2,560.00
$2,210.00
3
$8,000.00
19.200%
$1,536.00
$1,186.00
4
$8,000.00
11.520%
$921.60
$571.60
5
$8,000.00
11.520%
$921.60
$571.60
6
$8,000.00
5.760%
$460.80
$110.80