Question

Replacement Analysis

The Gilbert Instrument Corporation is considering replacing the wood steamer it currently uses to shape guitar sides. The steamer has 6 years of remaining life. If kept, the steamer will have depreciation expenses of $300 for 6 years. Its current book value is $1,800, and it can be sold on an Internet auction site for $4,500 at this time. Thus, the annual depreciation expense is $1,800/6=$300 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 $7,800, and has an estimated useful life of 6 years with an estimated salvage value of $900. 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 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 $1,500 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 the project cost of capital is 16%.

Should the old steamer be replaced? What is the NPV of the project? Round your answer to 2 decimal places.

Answer 1

First, we calclate the after tax salvage value of selling the old steamer.

Sale Pricwe =4500, Book Value =1800

Taxable value =4500-1800 =2700

taxes at 40% = 2700*0.4 = 1080

After tax salavge value =4500 -1080 = 3420

So Initial cash flow purchase of new steamer = 7800-3420 = 4380

The NPV of replcaement is as shown below:

Year	0	1	2	3	4	5	6
Initial Cash flow	-4380.00
Increase in Working Capital	-2200.00
Sales		2000.00	2000.00	2000.00	2000.00	2000.00	2000.00
Reducation in op. expense		1500.00	1500.00	1500.00	1500.00	1500.00	1500.00
Depreication		-1560.00	-2496.00	-1497.60	-898.56	-898.56	-449.28
Sale of new machine at end							900.00
Profit before taxes		1940.00	1004.00	2002.40	2601.44	2601.44	3950.72
Taxes at 40%		-776.00	-401.60	-800.96	-1040.58	-1040.58	-1580.29
Net Profit		1164.00	602.40	1201.44	1560.86	1560.86	2370.43
Add back depreciation		1560.00	2496.00	1497.60	898.56	898.56	449.28
Return of WC							2200.00
Net cash flow	-6580.00	2724.00	3098.40	2699.04	2459.42	2459.42	5019.71
NPV at 16%	$ 4,389.64

Yes, We have to replace the steam and the NPV of replacement = $4,389.64 (Positive)