1) Crackle and Pop Telephone Company is considering an upgrade to their current
ID: 2758135 • Letter: 1
Question
1) Crackle and Pop Telephone Company is considering an upgrade to their current call-waiting equipment. Their existing hardware was purchased 3 years ago for $150,000, has been depreciated straight line over a 5-year useful life (so, two years of depreciable life are remaining), and has an estimated current market value of $70,000. Bob Crackle (owner of the firm) estimates that the current equipment could probably last 5 more years (from today) at which time its market value will equal $0. A replacement piece of equipment costs $300,000, and can be depreciated straight line over 3 years. This new equipment will last 5 years, at which time its market (scrap) value will equal $10,000. Due to enhanced features, acquiring this new equipment would lead to a $10,000 revenue increase in the first year (t=1). These revenues would grow by $4,000 per year for the subsequent four years (t = 2, 3, 4, 5). (So, revenues will be $10,000, $14,000, 18,000….. higher.) In addition, due to its higher quality construction, it would lead to a decrease in operating expenses of $7,000 per year at times t =1,2,3,4, and 5. (So, expenses are lower by $7,000, $7,000, $7,000….) Due to the increase in revenues, accounts receivable will likely rise. Mr. Crackle estimate that AR will go from the exiting level of $12,000 to $18,000 at time 1, $20,000 at times 2, 3, and 4, and back to $12,000 at time 5. If the required return for this type of project is 12% and the tax rate is 40%, should the replacement piece of equipment be acquired? Be sure to provide quantitative justification for your answer.
Explanation / Answer
Current Value of Old Machine= $70000
Annual Depreciation = $150000/5= $30000
Book Value of Old Machine= 150000- (150000/5*3) = $60000
Capital Gain on sale = 70000-60000= $10000
Tax on Cap. Gain (40%)= 10000*.40= $4000
Net Value of Old Machine (Current Value-Tax) = 70000-4000= $66000 (Relevant Value)
New Equipment Cost= $300000
Depreciation per year on new Equipment= $300000/3= $100000
Salvage of New Machine at year 5 = $10000
Book Value= NIL
Net Inflow at year 5 after tax on gain = $10000-40%= $6000
Calculation of Incremental CASHFLOW
Calculation of NPV of Incremental CASHFLOW-
NPV of Incremental Cashflow is Negative Hence Machine should not be replaced.
Year 1 2 3 4 5 Increase in Receivable $6,000.00 $8,000.00 $8,000.00 $8,000.00 $0.00 Interest Cost on Increased Receivable $720.00 $960.00 $960.00 $960.00 $0.00 Tax Saving on Interest $288.00 $384.00 $384.00 $384.00 $0.00 Net Cost of Increased Receivable $432.00 $576.00 $576.00 $576.00 $0.00Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.