Replacement Analysis

Question

Kindly help with this:

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 13%.

Should it replace the old steamer?

My solution:

Old machine

Step#1 - Calculate PV of tax savings on depreciation

Step#2 - PV of salvage value

Answer - NPV $1,207.47

New machine

Step # 1 - Cost after sale of old machine and tax on gain of sale of old machine $7,080

Step # 2 - Working capital investment $2,200

Step # 3 - Incremental cash flow each year $2,000+$1,400-$Dep each year under macrs

Step # 4 - less Tax @40% and add back Dep

Step # 5 - working capital recovery in year 6 and sale of new machine after tax

NPV = $3,423.36

Answer 1

Wow! This requires a full excel sheet setup. Speaking honestly, I would do this for a paid candidate but not a free Q&A….this is quite an extensive problem!

That said, your setup looks to be correct. The most important is that you have used the appropriate NPV formula (to the power of the year) for each year.

Answer 2

Hi there,

High-level the approach makes sense.

I would recommend you also use ChatGPT for detailed feedback on such questions. It can help validate your approach and/or give feedback on it. Try it - it's actually quite fun.

You can also prompt it to provide elegant / short approaches to solving the problem.

The most important thing with calculation questions is dividing the question into steps that you can deal with in turn. Feel free to reach out and I can share a complimentary guide on this.

Best,
Cristian

Answer 3

Hi there,

approach looks fine. Key to avoid the trap here is to focus on modelling the Cashflows for both scenarios, not Profits (→ impact of treatment of depreciation), when deriving NPV.

Wish you all the best.

Regards, Andi