The Gilbert Instrument Corporation is considering replacing the wood steamer it

Question

The Gilbert Instrument Corporation is considering replacing the wood steamer it currently uses to shape guitar sides. The steamer, purchased just 2 years ago, is being depreciated on a straight-line basis and has 6 years of remaining life. Its current book value is $1,800, and it can be sold on an Internet auction site for $4,500 at this time. Thus, the annual depreciation expense is $1,800/6=$300 per year. 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 $8,000, and has an estimated useful life of 6 years with an estimated salvage value of $800. 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 16%. Should it replace the old steamer?

Explanation / Answer

Workings:

Schedule of annual cash flow: Years 1 2 3 4 5 6 Total Rise in sale 2000 2000 2000 2000 2000 2000 Saving in cost 1400 1400 1400 1400 1400 1400 Less: rise in Depreciation 1300 2260 1236 621.6 621.6 160.8 Net Profit before tax 2100 1140 2164 2778.4 2778.4 3239.2 Tax @40% 840 456 865.6 1111.36 1111.36 1295.68 Profit after tax 1260 684 1298.4 1667.04 1667.04 1943.52 Add: Rise in depreciation 1300 2260 1236 621.6 621.6 160.8 Cash flow 2560 2944 2534.4 2288.64 2288.64 2104.32 Discount factor@16% (1.16^-n)             0.862              0.743             0.641             0.552             0.476             0.410 Present vAlue       2,206.90        2,187.87       1,623.68       1,264.00       1,089.65           863.70        9,235.80 Present value of release of working capital 2900*.410 1189 Present value of cash inflow      10,424.80 Less: Initial outlay    14,320.000 NPV -3,895.20 Due to negative NPV old dteamer should not be replaced.

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