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 $8,100, 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 $1,600 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 15%. Should it replace the old steamer? What is the NPV of the project? Do not round intermediate calculations. Round your answer to the nearest dollar. $

Answer 1

Calculation of Net Present value is as follows:

Intitial Cash Outlay for the project:

= Sale value of old steamer after tax - Cost of New steamer - Investment in working capital

Cost of new steamer = $8100

Sale value of old steamer after tax = 4500 * (4500 - 1800)*40% = $3420

Investment in working Capital = Increase in Inventory - increase in payables

= 2900 - 700 = $2200

Intitial Cash Outlay for the project: 3420 - 8100 - 2200 = -6880

Net Present Value	0	1	2	3	4	5	6
Increase in Sales		2000	2000	2000	2000	2000	2000
Operating Expenses saved		1600	1600	1600	1600	1600	1600
Less Increase in Depreciation *		1320	2292	1255.2	633.12	633.12	166.56
Earning before Tax		2280	1308	2344.8	2966.88	2966.88	3433.44
Less tax (40%)		912	523.2	937.92	1186.75	1186.75	1373.37
Net Income		1368	784.8	1406.88	1780.12	1780.12	2030.06
Add Depreciation		1320	2292	1255.2	633.12	633.12	166.56
Operating Cash Flow		2688	3076.8	2662.08	2413.24	2413.24	2196.62
Add salvage value of new steamer after tax							540 [900*(1 - 40%)]
Less salvage value of old steamer after tax							-480 [800*(1 - 40%)]
Intitial Cash Outlay	-6880
Working Capital Recovered							2200
Net Cash Outflow	-6880	2688	3076.8	2662.08	2413.24	2413.24	4453.24
Discount Rate (15%)	1.0000	.8695	.7561	.6575	.5717	.4971	.4323
Present Value	-6880	2337.21	2326.36	1750.31	1379.65	1199.62	1925.13
NPV (Sum of PVs)	4038.28

* Incremental Depreciation for the period is calculated as below :

Incremental Depreciation	1	2	3	4	5	6
Cost of New Steamer	8100	8100	8100	8100	8100	8100
MACRS 5 year depreciation rate	20%	32%	19.20%	11.52%	11.52%	5.76%
New Depreciation	1620	2592	1555.2	933.12	933.12	466.56
Old Depreciation	300	300	300	300	300	300
Change in Depreciation	1320	2292	1255.2	633.12	633.12	166.56

The Net Present value comes out to be 4038.28 and it is positive , so the old steamer should be replaced with the new one.