EXERCISE $26\mathrm{.}10$

Replacing Existing Equipment EnterTech has noticed a significant decrease in the profitability of its line of its wireless head$-$

phones. 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 this particular model of wireless headphones 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.

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

b$.$ What nonfinancial factors should EnterTech consider?

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?

Assume the following:

$*$The tax effect from the sale of the old machine at t$=0($either a tax refund or required tax payment$)$ will occur at t$=1$

$*$The old machine still has $5$ years' worth of depreciation; it's being depreciated toward a $$0$ salvage value using straight$-$line depreciation