Question: As a financial manager of a company that produces and sells window glass, you have been recently asked to analyze alternatives to replacing an old furnace. In the glass-making process, before glass is formed, the glass batch - a mix of glass ingredients, which include silicon dioxide, sodium oxide, calcium oxide, and other additives - is melted at high temperature. The process can be both energy and time consuming, depending on the furnace and the volume of production.
The furnace the company currently uses has been installed 4 years ago at the cost of $1M, and nears the end of its useful life in December this year. After December, it can no longer be operated, because there is no possibility to refurbish it and in any way prolong its useful life. The annual depreciation on the old furnace was $200,000 per year, so at the end of its life it will have book value of $200,000. Unfortunately, there are no buyers for the old furnace and the company has to scrap it.
The old furnace has been rather inefficient, however. The annual energy cost associated with the furnace has averaged $250,000 per year, and it required six employees to operate it at the annual cost of $50,000 per employee. In addition, the inefficient design of the old furnace required time to heat the glass batch up. The chief operating officer estimated that the inefficiency resulted in productivity loss equivalent to one week worth of delays per year.
As regards new furnaces, the company has two alternatives. The first alternative is an electric furnace that costs $600,000 to buy and install. It has a useful life of 3 years. However, due to the relatively high costs of electricity, annual operating costs are estimated to be $200,000 per year in electricity and $20,000 per year in operator salaries. You determined that it is possible to use the accelerated depreciation schedule for the electric furnace and depreciate it straight-line over five years to the salvage value of zero. In fact, at the end of its useful life, you expect the electric furnace to have no value.
The second alternative is a gas furnace that costs $900,000 to buy and install. It has a useful life of 5 years. Because natural gas is relatively cheap, annual operating costs are estimated to be $100,000 per year in electricity but, due to the relative complexity of the machine, two operators will be needed at the total cost of $30,000 per year for the two. You determined that the company can depreciate the electric furnace straight-line to the salvage value of zero. Even though it will have the book value of $0 at that time, at the end of its useful life, the gas furnace can be sold for $100,000. In addition to these costs, the gas furnace will require an increase in inventories of 150,000 to hold a supply of liquid gas tanks during the operation of the machine. These inventories will be recovered at the end of the useful life of the machine.
Both of these furnaces reduce a week's worth of delays in production process. For the past year, total sales for the company are predicted to reach $10,000,000, costs of goods are predicted at $7,000,000, and days of sales in inventories are 35 days (using 350 days as the number of working days per year).
The company faces a corporate tax rate of 35%, and you estimated that the discount rate which should be used for this project is 10% per year.
What should the company do?