Question

Philadelphia Fastener Corporation manufactures nails, screws, bolts, and other fasteners. Management is considering a proposal to acquire new material-handling equipment. The new equipment has the same capacity as the current equipment but will provide operating efficiencies in labor and power usage. The savings in operating costs are estimated at $150,000 annually.

The new equipment will cost $300,000 and will be purchased at the beginning of the year when the project is started. The equipment dealer is certain that the equipment will be operational during the second quarter of the year it is installed. Therefore, 60 percent of the estimated annual savings can be obtained in the first year. The company will incur a one-time expense of $30,000 to transfer production activities from the old equipment to the new equipment. No loss of sales will occur, however, because the processing facility is large enough to install the new equipment without interfering with the operations of the current equipment. The equipment is in the MACRS 7-year property class. The firm would depreciate the machinery in accordance with the MACRS depreciation schedule.

The current equipment has been fully depreciated. Management has reviewed its condition and has concluded that it can be used an additional eight years. The company would receive $10,000, net of removal costs, if it elected to buy the new equipment and dispose of its current equipment at this time. The new equipment will have no salvage value at the end of its life. The company is subject to a 40 percent income-tax rate and requires an after-tax return of at least 12 percent on any investment.

Use Appendix A and Exhibit 16-9 for your reference. (Use appropriate factor(s) from the tables provided.)

Required:

1. 1.Calculate the annual incremental after-tax cash flows for Philadelphia Fastener Corporation’s proposal to acquire the new equipment.

2. 2-a. Calculate the net present value of the proposal to acquire the new equipment using the cash flows calculated in requirement (1), Assume all cash flows take place at the end of the year.

3. 2-b. Should management purchase the new equipment?

Answer 1

2 (b) Management should buy the new equipment because of positive npv.