Case Study: Zollner Electroplating Company

One of the pieces of equipment used in electroplating products at the Zollner Electroplating Company has been in use for five years and is being considered for replacement. The new equipment being considered to replace it would save $28,000 a year in production and related costs.

When the old equipment was purchased five years ago, it cost $40,000 for the equipment itself. There was also a charge of $500 to deliver the equipment to the factory and another $3,000 to install it. No operator training was necessary. At the time of purchase, it was thought that the equipment would last 10 years and have a salvage value of $5,000. Its current market value is $10,000. The company is using the straight-line method to depreciate the equipment.

The new equipment the company contemplates buying would cost $65,000. It would cost $1,000 to deliver it to the factory and $6,500 to install it in place of the old. It would also cost Zollner $500 to send a worker to the equipment manufacturer’s plant for training in operating the equipment.

The new equipment would be put into operation in the first quarter of Zollner’s financial year. MACRS would be used to depreciate the new equipment. MACRS uses a life of seven years for this type of manufactur- ing equipment and a salvage value of zero. However, Zollner’s industrial engineer estimates that they would get rid of the new equipment at the end of five years, at which time they could sell it for $6,000.

Zollner’s cost of capital for buying the equipment would be 13 percent. They expect that any future annual benefits from the new equipment could be invested at 13 percent. Zollner’s tax rate is 40 percent.

1. Calculate the net present value, internal rate of return, modified internal rate of return, and break-even point in years for replacing the old equipment with the new equipment. 2. Prepare a chart showing the change in the replacement’s net present value with time over the five-year analysis period. Include grid lines for both the X and Y axes of the chart. Label both axes. Indicate the break-even point on the chart.

(Continued)

420 ❧ ® Corporate Financial Analysis with Microsoft Excel

Figure฀13-12

Equipment Replacement for Zollner Electroplating

1 ZOLLNER ELECTROPLATING COMPANY 2 Equipment Replacement Analysis

Equipment Information

Old

New

Company Information

Machine

4 Machine price

Marginal Tax Rate 40% 5 Expected life, years

10 5 Required Rate of Return 13% 6 Expected end-of-life salvage value

7 Depreciation method

St. Line

MACRS

8 Delivery to factory

10 Operator training

11 “Ready-to-go” cost of equipment

12 Years of use to date

13 Current market value

14 Annual saving in operating costs

15 Year 0 1 2 3 4 5 16 Cash flows and calculations associated with replacing old equipment with new

17 “Ready-to-go” cost of new equipment (cash outflow)

18 Sale of old equipment

19 Accumulated depreciation for old equipment

20 Book value of old equipment

21 Taxable gain(loss) from sale of old equipment

22 Capital gain tax on sale of old equipment

23 After-tax cash flow from sale of old equipment

24 Net cash flow for replacing old equipment with new

25 Annual saving in operating costs

26 Calculations of depreciation and taxes for replacement option

27 Depreciation foregone on old equipment

$3,850 $3,850 $3,850 28 MACRS depreciation for new equipment

15.31% 10.93% 8.75% 29 Depreciation allowed on new equipment

11,176 $ 7,979 $ 6,388 30 Net depreciation allowance for replacement option

7,326 $ 4,129 $ 2,538 31 Taxable operating income

20,674 $ 23,871 $ 25,463 32 Income tax on operating income

33 Net after-tax cash flow from operating income

19,731 $ 18,452 $ 17,815 34 Adjustment for sale of new equipment at end of year 5

35 Cash inflow from sale (i.e., selling price) $ 6,000 36 Book value

$ 13,563 37 Capital loss from selling new equipment

$ 7,563 38 Capital loss tax benefit

39 After-tax cash flow from sale of new equipment $ 9,025 40 Total after-tax cash flow for replacement option

44 Break-even point, years

(Continued)

Capital Budgeting: Applications ❧ 421

Solution: Figure 13-12 is a spreadsheet solution. 1. The spreadsheet of Figure 13-12 is divided into five modules. From top to bottom, they are

(1) Input data and calculations (2) Analysis of the replacement cost at year 0 (3) Analysis of the replacement’s year-end benefits on operating income for years 1 to 4 (4) Analysis of the sale of the new equipment at the end of year 5 (5) Determination of the total after-tax cash flows and their effects on NPV, IRR, MIRR, and break-even

point. You can, of course, combine entries and shorten the spreadsheet. There is no harm in doing that if the programmer has the ability to do so. However, many students (even good ones, in the author’s experience) lose their way in the details and the tax consequences of selling and buying, depreciating the new and losing the depreciation of the old, and so forth. Showing all the steps better exposes the logic and avoids omissions and mistakes. From a management standpoint, the type of organization shown in Figure 13-12 provides a better understanding of how money is flowing in and out, and why.

The “ready-to-go” cash outflows for the old and new equipment are calculated by entering =B4+SUM(B8:B10) in Cell B11 and copying the entry to C11. The cash outflow for paying for the “ready-to-go” cost of the new equipment is entered as -C11 in Cell B17. The cash inflow from the sale of the old equipment is entered as =B13 in Cell B18. The five years of accumulated straight-line depreciation for the old equipment is calculated as =(B5-B12)*(B11-B6)/B5 in Cell B19. The book value of the old equipment is calculated as =B11-B19 in Cell B20. The taxable capital gain or loss on the sale of the old equipment is calculated as =B18-B20 in Cell B21. Because the selling price of $10,000 is less than the book value of $24,250, there is a capital loss of $14,250. This generates a tax saving or cash inflow of $5,700, which is calculated in Cell B22 by the entry =-G4*B21. The after-tax cash flow from the sale of the old equipment is calculated by the entry =B18+B22 in Cell B23, which is the sum of the selling price plus the tax saving due to the capital loss. The net cash flow for replacing the old equipment with the new is calculated by the entry =B17+B23 in Cell B24. This value is repeated in Cell B25 as the total after-tax cash flow at year 0.

The annual savings in operating costs for years 1 to 5 are entered in Row 25 by copying the entry =$C$14 in Cell C25 to D25:G25. To calculate the net allowance for depreciation, we need to subtract the depreciation that has been given up for selling the old equipment from the depreciation for the new equipment. This is accomplished by the following steps: The straight-line depreciation foregone on the old equipment is calculated by entering =($B$11-$B$6)/$B$5 in Cell C27 and copying it to D27:G27. The MACRS depreciation allowance for the new equipment is calculated by entering the appropriate percentage values from Table 11-2 in Chapter 11 into Cells C28:G28, entering =C28*$C$11 in C29, and copying the entry in C29 to D29:G29. The net depreciation allowance is calculated by entering =C29-C27 in C30 and copying to D30:G30. The taxable operating income is calculated by entering =C25-C30 in Cell C31 and copying to D31:G31. The tax on the operating income is calculated by entering =$G$4*C31 in C32 and copying to D32:G32. The net after-tax cash flow from operating income is calculated by entering =C25-C32 in Cell C33 and copying to D33:G33.

The entry in Cell G35 for the cash inflow from selling the new equipment at the end of year 5 is =C6. The book value of the new equipment at the time of sale is calculated in Cell G36 by the entry =C11-SUM(C29:G29). Because the book value is more than the selling price, there is a capital loss that is calculated in Cell G37 by the entry =G36-G35. This results in a capital loss tax benefit calculated in Cell G38 by entry =G4*G37. The after-tax cash from the sale of the new equipment is calculated by the entry G35+G38 in Cell G39.

(Continued)

422 ❧ Corporate Financial Analysis with Microsoft Excel ®

Values for the total after-tax cash flow for the replacement option are calculated by entering =B24+B33+B39 in Cell B40 and copying the entry to C40:G40. Values for the net present value, internal rate of return, modified internal rate of return, and break-even point are calculated from the total after-tax cash flow in the same manner as before.

2. Figure 13-13 shows the net present value of the replacement option as a function of the number of years from the time of the investment. The break-even point is 3.60 years.

Figure฀13-13

Net Present Value vs. Time for Equipment Replacement Proposal

ZOLLNER ELECTROPLATING COMPANY

Equipment Replacement Analysis

Break-Even Point = 3.60 years

ALUE V $(10,000)

NET PRESENT $(50,000)

YEARS FROM EQUIPMENT AVAILABILITY

Case Study: Zollner Electroplating Company