Michigan Motor Company is considering a proposal to acquire new manufacturing equipment. The new equipment has the same capacity as the current equipment but will provide operating efficiencies in direct and indirect labor, direct material usage, indirect supplies, and power. Consequently, the savings in operating costs are estimated to be $150,000 annually.
The new equipment will cost $300,000 and will be purchased at the beginning of the year when the project is started. The equipment dealer is certain that the equipment will be operational during the second quarter of the year it is installed. Therefore, 60 percent of the estimated annual savings can be obtained in the first year. Michigan Motor will incur a one-time expense of $30,000 to transfer the production activities from the old equipment to the new equipment. No loss of sales will occur, however, because the plant is large enough to install the new equipment without disrupting operations of the current equipment. The equipment dealer states that most companies use a 4-year life when depreciating this equipment. The current equipment has been fully depreciated and is carried in the accounts at zero book value.
Management has reviewed the condition of the current equipment and has concluded that it can be used an additional four years. Michigan Motor would receive $5,000 net of removal costs if it elected to buy the new equipment and dispose of its current equipment at this time. Michigan Motor currently leases its manufacturing plant. The annual lease payments are $60,000. The lease, which will have four years remaining when the equipment installation would begin, is not renewable.
Michigan Motor would be required to remove any equipment in the plant at the end of the lease. The cost of equipment removal is expected to equal the salvage value of either the old or the new equipment at the time of removal. The company uses the sum-of-the-years'-digits depreciation method for tax purposes. A full-year's depreciation is taken in the first year an asset is put into use. The company is subject to a 40 percent income tax rate and requires an after-tax return of at least 12 percent on an investment.
a. Calculate the annual incremental after-tax cash flows for Michigan Motor Company's proposal to acquire the new manufacturing equipment.
b. Calculate the net present value of Michigan Motor's proposal to acquire the new manufacturing equipment using the cash flows calculated in part (a) and indicate what action Michigan Motor's management should take. Assume all recurring cash flows occur at the end of the year.