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 $11,000, and has an estimated useful life of 6 years with an estimated salvage value of $1,100. 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 $1,400 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 14%.

The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below.

Answer 1

Compute After-tax sale revenue increase as follows:

Purchase price	($11,000)
Sale of old machine	$4,150
Tax on sale of old machine ($4150 - $3575) × 40%	($230)
Net operating working capital (-$2900 + $700)	($2,200)
Cash flows year 0	($9,280)
Sales increase	$2,000
Costs decrease	$1,400
Total increase in pre-tax revenue	$3,400
Less: Tax ($3400 × 40%)	($1,360)
After-tax sales revenue increase ($3400 - $1360)	$2,040

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Compute depreciation tax savings as follows:

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
New machine depreciation (as per rates given) (A)	$2,200	$3,520	$2,112	$1,267.20	$1,267.20	$633.60
Less: old machine depreciation (B)	($650)	($650)	($650)	($650)	($650)	($325)
Change in depreciation [C = A-B]	$1,550	$2,870	$1,462	$617	$617	$309
Depreciation tax savings [C × 40%]	$620.0	$1,148.0	$584.80	$246.88	$246.88	$123.44

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Compute NPV as follows:

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Net Investment	($9,280)
After-tax sales revenue increase		$2,040	$2,040	$2,040	$2,040	$2,040	$2,040
Depreciation tax savings @40%		620	1148	584.8	246.88	246.88	123.44
Working capital recovery							$2,200
After tax salvage value of new machine [($1100 × (1-0.40)]							$660
Opportunity cost of old machine [($800 × (1-0.40)]							($480)
Project cash flows (A)	($9,280)	$2,660	$3,188	$2,625	$2,287	$2,287	$4,543
PVF@14%	1	0.87719	0.76946	0.67497	0.59208	0.51936	0.45558
Present value of cash flows	($9,280)	$2,333	$2,453	$1,772	$1,354	$1,188	$2,070
NPV ($11,170 - $9,280)	$1,890

As NPV is positive therefore should replace new machine proposal