Question

EnterTech 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 EnterTech should (1) buy new equipment at a cost of $120,000 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. EnterTech 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. EnterTech 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. (Round your "PV factors" to 3 decimal places.)

Answer 1

	Cash flow per year from new machine:
					$
	Savings in manufacturing cost				34000
	Less: Depreciation
	(Cost/Useful life)		(120000/5)		24000
	Income before tax				10000
	Less: Tax at 40%				4000
	Net income				6000
	Add: Depreciation				24000
	Cash flow per year from new machine				30000
	Net present value:
	Year	Particulars			Amount	PV at 12%	Present value
					a	b	a*b
	0	Acquisition cost			-120000	1	-120000
	0	Salvage value of old equipment			20000	1	20000
	1 to 5	Cash flow per year			30000	3.605	108150
		Total					8150
	Net present value of the new machine=$ 8150