Question

VacuTech is a high-technology company that manufactures sophisticated instruments for testing microcircuits. Each instrument sells for $3,500; variable manufacturing cost per unit (all cash) equals $2,450. An essential component of the company’s manufacturing process is a sealed vacuum chamber where the interior approaches a pure vacuum. The technology of the vacuum pumps that the firm uses to prepare its chamber for sealing has been changing rapidly. On June 1, 2015, VacuTech bought the latest in electronic high-speed vacuum pumps that can evacuate a chamber for sealing in only 6 hours. The company paid $400,000 for the pump. Recently, the pump’s manufacturer approached VacuTech with a new pump that would reduce the evacuation time to 2 hours. VacuTech’s management is considering the purchase of this new pump and has asked Doreen Harris, the company controller, to evaluate the financial impact of replacing the existing pump with the new model. Doreen has gathered the following information prior to preparing her analysis: The new pump could be installed and placed in service on January 1, 2019. The pump’s cost is $608,000; installing, testing, and debugging the machine will cost $12,000 (which should be capitalized). The pump would be assigned to the 3-year class for depreciation under the Modified Accelerated Cost Recovery System (MACRS) and is expected to have an $80,000 salvage value when it is sold at the end of 4 years. Depreciation on the equipment would be recognized starting in 2019, and MACRS rates (rounded) would be as follows: Year 1 33 % Year 2 45 Year 3 15 Year 4 7 The current pump is being depreciated under MACRS and will be fully depreciated by the time the new pump is placed in service. If the firm purchases the new pump, it will sell the current pump for a net price of $50,000. At the current rate of production, the new pump’s greater efficiency will result in annual pretax cash savings of $125,000. VacuTech is able to sell all testing instruments that it can produce. Because of the new pump’s increased speed, output is expected to increase by 30 units in 2019, 50 units in both 2020 and 2021, and 70 units in 2022. Cash-based manufacturing costs for all additional units would be reduced by $150 per unit (in addition to the $125,000 savings noted above). VacuTech is subject to a 40% income tax rate. For evaluating capital investment proposals, management assumes that annual cash flows occur at the end of the year and uses a 15% after-tax discount rate.

1. Calculate the net present value (NPV) at January 1, 2019, of the estimated after-tax cash flows that would result from its acquisition. (Use the built-in NPV function in Excel to estimate the NPV of the proposed investment.)

Answer 1

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Ans :

Particulars	2019	2019	2020	2021	2022	Total NPV
	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4
Cash Operating Savings		125000	125000	125000	125000
Depreciation Tax Shield ( note 1)		204600	279000	93000	43400
Contribution earned on increase in output due to new machine ( note 2 )		36000	60000	60000	84000
Profit on sale of old equipment	50000
Salvage of new equipment in last yr					80000
a)Total additional cash flow	50000	365600	464000	278000	332400
b)Less: tax effect (a*40%)	20000	146240	185600	111200	132960
c)Cash Saving After Tax (a-b)	30000	219360	278400	166800	199440
d)Deprecation Tax Shield		204600	279000	93000	43400
e)Purchase of New Equipment ( 608000 + 12000)	-620,000
f)Increase in Cash Flows After Tax (c+d+e)	-590000	4,23,960	5,57,400	2,59,800	2,42,840
g)Discount Factor (1/1.15)^ n	1	0.8696	0.7561	0.6575	0.5718
h)Present Value (f* g)	-590000	368661	421474	170823	138845	509803
As per the above calculation, the NPV of replacing the old system with new system is $ 509803, hence the system should not be replaced.

Note1 : depreciation

Yr 1 = 620000 * 33 % = 204600

Yr 2 = 620000 * 45 % = 279000

Yr 3 = 620000 * 15 % = 93000

Yr 4 = 620000 * 7 % =    43400

Note – 2 ) Contribution earned on increase in output due to new machine

S.P. per unit = 3500

Less : variable manufacturing cost per unit = 2450 – 150 ( decrease in cost , mentioned in 5^th last line of the sum) = 2300

Contribution per unit = 3500 – 2300 = 1200 per unit

Total saving in yr 1 = 1200 * 30 units = 36000

Total saving in yr 2 = 1200 * 50 units = 60000

Total saving in yr 3 = 1200 * 50 units = 60000