Question
mith Inc. owns an industrial furnace which it bought for $5,000,000. The furnace had an estimated useful life of 8 years and a salvage value
mith Inc. owns an industrial furnace which it bought for $5,000,000. The furnace had an estimated useful life of 8 years and a salvage value of $150,000. The furnace has been in service for 5 years and Smith Inc. has depreciated the furnace using the straight-line method (as a result, the balance in accumulated depreciation is $3,031,250). Smith Inc. is considering replacing the old furnace with a new furnace. If Smith Inc. disposes of the old furnace, it will be able to sell the old furnace for $2,000,000 but the company will have to pay shipping costs of $12,000 in order to get rid of the old furnace.
The new furnace would cost Smith Inc. $6,000,000. In addition, Smith Inc. will have to pay a delivery fee of $6,000 and installation charges of $4,000. The new furnace is expected to produce annual operating revenues of $2,000,000 and incur $400,000 in annual operating expenditures. Smith Inc. will also incur annual non-tax deductible environmental impact fees of $5,000. In the first year of operation of the new furnace, Smith Inc. will have to train employees on the new furnace at a cost of $35,000. Due to high employee turnover, Smith Inc. will again incur this training cost in year 3 of operating the new furnace.
Additional Information:
For financial accounting and tax purposes Smith Inc. will depreciate the new furnace using the straight-line method of depreciation. The estimated useful life is 6 years and the salvage value for depreciation is estimated to be $40,000.
Smith Inc. estimates they will be able to sell the new furnace at the end of its useful life for $20,000.
Smith Inc. operates in a 30% tax-bracket for the entire period.
Management at Smith Inc. requires an 8 % return on all new investments.
Questions
-Calculate the NPV of the proposed investment in the new furnace. Should Smith Inc. go ahead with the project? (12 Points)
- Calculate the payback period for the proposed investment described above. (7 points)
- Discuss how the NPV of the project would change if management's required rate of
return was higher than 8%? Similarly, what if management's required rate of return was
below 8%? (5 points)
- Discuss how the use of an accelerated depreciation method instead of the straight-line
method would affect the NPV of any proposed capital investment? (4 points)
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