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
The NPV of replacing the old steamer with the new Side Steamer 3000 is positive ($61,860.15), indicating that it is financially beneficial to replace the old steamer. Therefore, Gilbert Instrument Corporation should replace the old steamer with the new one.
Your effort in creating it is greatly appreciated; it is really informative.