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
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 263 and 264.
c. If the manager of EnterTech is uncertain about the accuracy of the cost savings estimate, what actions could be taken to double-check the estimate?
| 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 | ||
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