Question

EnterTech has noticed a significant decrease in the profitability of its line of portable CD players. The production manager believes that the source of the trouble is old, inefficient equipment used to manufacture the product. The issue raised, therefore, is whether EnterTech should (1) buy new equipment at a cost of $120,000 or (2) continue using its present equipment.

It is unlikely that demand for these portable CD players will extend beyond a five-year time horizon. EnterTech estimates that both the new equipment and the present equipment will have a remaining useful life of five years and no salvage value.

The new equipment is expected to produce annual cash savings in manufacturing costs of $34,000, before taking into consideration depreciation and taxes. However, management does not believe that the use of new equipment will have any effect on sales volume. Thus, its decision rests entirely on the magnitude of the potential cost savings.

The old equipment has a book value of $100,000. However, it can be sold for only $20,000 if it is replaced. EnterTech has an average tax rate of 40 percent and uses straight-line depreciation for tax purposes. The company requires a minimum return of 12 percent on all investments in plant assets.

	New Machine
120,000	Cost of Investment
5	Years
34,000	Cash Savings
-	Salvage value at end of life
24,000	Annual Depreciation

	Old Machine
100,000	Book Value of old machine
20,000	Current sales value of old machine
20,000	Annual Depreciation
12%	Required Rate of Return
40%	Tax Rate

a. Compute the net present value of the new machine using the tables in Exhibits 26–3 and 26–4.

a	Net present value calculation of cash flows:
		Calculate depreciation expense under each alternative:
	24,000	New Machine
	20,000	Old Machine
	4,000	Increase in depreciation of new machine
		Calculate the incremental increase in annual income taxes resulting from the purchase of the new machine:
	34,000	Cash savings of new machine
	(4,000)	Less: Increase in depreciation (see above)
	30,000	Increase in pretax income
	40%	Income tax rate
	12,000	Increase in income taxes
		Calculate the incremental increase in annual cash flow resulting from the purchase of the new machine:
	34,000	Cash savings of new machine
	(12,000)	Less: Increase in income taxes (see above)
	22,000	Increase in annual cash flow
		Calculate the tax savings resulting from the loss on the sale of the old machine:
	100,000	Book value of old machine
	(20,000)	Proceeds from sale
	80,000	Loss on sale of disposal
	40%	Income tax rate
	32,000	Tax savings resulting from loss on disposal
	The net present value of the new machine can now be computed as follows:		Factor
	79,310	Present value of incremental annual cash flows	3.605
	28,576	Present value of tax savings from loss on disposal of the old machine	0.893
	20,000	Present value of proceeds from sale of old equipment	1.000
	127,886	Total present value
	(120,000)	Less: Cost of new machine	1.000
	7,886	Net present value

b. What nonfinancial factors should EnterTech consider?

Answer 1

a. Net Present Value of the new machine replaces

Calculation of cash flows:	Amount
Net increase in Depreciation
New Machine Depreciation	24,000
Old Machine Depreciation	20,000
Increase in depreciation expences	4,000
Incremental increase in annual income
Cash savings of new machine	34,000
Less: Increase in depreciation	(4,000)
Increase in pretax income	30,000
Income tax rate	40%
Increase in income taxes Expences	12,000
Incremental increase in annual cash flow
Cash savings of new machine	34,000
Less: Increase in income taxes	(12,000)
Increase in annual cash flow	22,000
Tax savings on loss of old machine sale
Book value of old machine	100,000
Proceeds from sale	(20,000)
Loss on sale of disposal	80,000
Income tax rate	40%
Tax savings	32,000

Particular	Amount	NPV Factor	NPV
Increase in annual cash flow	22,000	3.605	79,310
Tax savings on loss of old machine sale	32,000	0.893	28,576
Sale value of old machine	20,000	1	20,000
Total Present value of Incremental Income			1,27,886
Less - Cost of purchase of new machine			1,20,000
Net Present Value			7,886

B. Following nonfinancial factors EnterTech should consider

1. Whether the existing employees are capable to handle the new machine?

2. Whether exactly same quality of product is manufactured from the new machine?

3. Is there any impact on the selling price of the product?