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

Year	Cash Flow	12%	PV
0	-68000	1	-68000
1	22000	0.893	19646
2	22000	0.797	17534
3	22000	0.712	15664
4	22000	0.636	13992
5	22000	0.567	12474
			11310

Working :

Cash Outflow	120000
Less: Inflow by selling old equipment	-20000
Less: Income tax benefit on loss on sale	-32000
(100000 Book Value-20000 Sale Value)*40%
Net Cash Outflow	68000 Annual Saving 34000 Less: Tax on Saving 40% -13600 Add: Tax on Dep Saving (24000-20000)*40% 1600 22000