Question

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 $650 for 5 years and $325 for the sixth year. Its current book value is $3,575, and it can be sold on an Internet auction site for $4,150 at this time. 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 $13,000, and has an estimated useful life of 6 years with an estimated salvage value of $1,300. 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 would allow for an output expansion, so sales would rise by $2,000 per year; even so, 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 its WACC is 13%.Required:A) Should it replace the old steamer?B) What is the NPV of the project? (Round your answer to the nearest dollar.)

Answer 1

Solution:

Purchase price -13,000

Sale of old machine 4150

Tax on sale of old machine -230

Change in net working capital -2200

Total investment 10,280

a. The market value reaches $4,150-$ 3,550= USD 600. Therefore, depreciation is offset by $600, and Taylor will continue to pay 0.40($600)= $240 in taxes

b. Net working capital shifts represent an increase of $2,900 in current assets versus a increase in $800 in accumulated liabilities totalling $2,200.

Examining the annual cash inflows:Sales increase 2,000

Cost decrease 1,900Increase in pre-tax revenues 3,900

After-tax revenue increase:$3,900(1-T) = $3,900(.60) = $2,340

Project cash flows:Initial outlay = -10,280

Year 1 = 3,040

Year 2 =3,616

Year 3 =3,002

Year 4 = 2,633

Year 5 = 2,633

Year 6 = 5,106

NPV of the project = $2,093.42 at WACC of 15%

The NPV of this incremental cash flow stream, when discounted at 15% is $2,083.51. Thus, the replacement should be made.