E26.10 Enter Tech has noticed a significant decrease in the profitability of its
ID: 2492517 • Letter: E
Question
E26.10
Enter Tech has noticed a significant decrease in the profitability of its line of portable CD players. 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 Enter Tech should (1) buy new equipment at a cost of s120,000 or (2) continue using its present equipment. It is unlikely that demand for these portable CD players will extend beyond a five-year time horizon. Enter Tech 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. Enter Tech 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 Enter Tech is uncertain about the accuracy of the cost savings estimate, what actions could be taken to double-check the estimate?Explanation / Answer
Cost of new equipment = $120,000
Book value of old equipment = $100,000
Sale value of old equipment = $20,000
There is no gain on sale of old equipment. There will no tax liability on sale of old equipment and hence the sale value of $20,000 shall be the net cash receipt from the sale.
Net initial cash outflow at year 0 = Cost of new equipment – Sale of old equipment = $120,000 - $20,000 = $100,000
Annual cash savings due to new equipment = $34,000
Annual cash savings after tax = $34,000 * (1 – 0.40) = $20,400
Annual depreciation on new equipment = Cost of new equipment/Useful life = $120,000/5 = $24,000
Tax rate = 40%
Annual free cash inflows = Annual cost savings after tax + Tax savings on depreciation = $20,400 + ($24,000*0.40) = $30,000
Present value of $1 to be received in 5 periods at 12% = 3.605 (From Exhibit 26-4)
Present value of annual free cash flows from new equipment = $30,000 * 3.604 = $108,150
Net present value of new equipment = - Initial cash outflow + Present value of annual free cash flows = -$100,000 + $108,150 = $8,150
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