Question

Casper Ice Cream

The Casper Ice Cream Company is an ice cream manufacturer in Richmond, Utah famous for making Fat Boy Ice Cream Sandwiches. The owner, Mr. Casper, the grandson of the founder, is considering replacing an existing ice cream maker and batch freezer with a new maker which has a greater output capacity and operates with less labor. His only alternative is to overhaul his ice cream maker and batch freezer which have a current net book value of $6,000 and three years of remaining depreciable life (straight line). The equipment would cost $10,000 to overhaul but this would increase its useful life for 10 years which is also the life of the new machinery. Mr. Casper’s accountant tells him the new net book value of the overhauled equipment could be depreciated straight line over four years. The old machinery has zero salvage value currently.

The new maker and freezer would cost $50,000 including installation. It would be fully depreciated over 10 years and would have $3,000 salvage at the end of that period. Because of automatic features, the new equipment would allow labor saving of $9,000 per year.

Even though the new equipment has increase capacity, Mr. Casper does not feel any extra product could be sold until year five. At that time, he estimates that additional sales would result in additional net cash revenues before tax of $5,000 per year for the remaining life of the machine. By the end of year four, however, working capital would have to be increased by $3,000 to support the higher sales. This increase in working capital will be recovered at the end of the project, which will last for 10 years.

Casper Company is currently in the 30% tax bracket. Mr. Casper demands a rate of return of 16%.

Complete a NPV and IRR analysis

Answer 1

NPV & IRR analysis of the new maker decision
Installing a new maker:
Year	0	1	2	3	4	5	6	7	8	9	10
Initial cost	-50000
Cost of overhaul saved	10000
After-tax salvage(3000*(1-30%))											2100
NWC introduced & recovered					-3000						3000
Incremental depn.tax shields lost on overhauling exiting m/c(2500*30%)-(2000*30%)		-150	-150	-150	-750
Incremental after-tax labor savings(9000*1-30%))		6300	6300	6300	6300	6300	6300	6300	6300	6300	6300
Incremental after-tax net cash revenue(5000*(1-30%))						3500	3500	3500	3500	3500	3500
Incremental depn.tax shield(50000/10=5000*30%),10 yrs. 16%)		7250	7250	7250	7250	7250	7250	7250	7250	7250	7250
Incremental net annual cash flows	-40000	13400	13400	13400	9800	17050	17050	17050	17050	17050	22150
PV at 16%(1/1.16^Yr.n)	1	0.86207	0.74316	0.64066	0.55229	0.47611	0.41044	0.35383	0.30503	0.26295	0.22668
PV at 16%	-40000	11552	9958	8585	5412	8118	6998	6033	5201	4483	5021
NPV of new maker	31360
IRR of cash flows(of Row 19)	33%
Replacing the existing ice cream maker and batch freezer with a new maker is RECOMMENDED as
the NPV is POSITIVE &
IRR 33% > reqd. return 16%