Mom's Cookies Inc.is considering the purchase of a new cookie oven.The original cost of the old oven was $30,000;it is now 5 years old,and it has a current market value of $13,333.33.The old oven is being depreciated over a 10-year life towards a zero estimated salvage value on a straight line basis,resulting in a current book value of $15,000 and an annual depreciation expense of $3,000.The old oven can be used for 6 more years but has no market value after its depreciable life is over.Management is contemplating the purchase of a new oven whose cost is $25,000 and whose estimated salvage value is zero.Expected before-tax cash savings from the new oven are $4,000 a year over its full MACRS depreciable life.Depreciation is computed using MACRS over a 5-year life,and the required rate of return is 10 percent.Assume a 40 percent tax rate.What is the net present value of the new oven?
A) −$2,418
B) −$1,731
C) $1,568
D) $163
E) $1,731

Question

Quizplus · Accepted Answer

To calculate the net present value (NPV), we need to calculate the cash flows associated with both options.

For the old oven:

- Annual after-tax cash flow: $3,000 (depreciation) x 0.6 (tax rate) = $1,800
- Annual before-tax cash flow: $4,800
- Total before-tax cash flow over 6 years: $28,800
- Total after-tax cash flow over 6 years: $28,800 x 0.6 = $17,280

For the new oven:

- Initial investment: -$25,000
- Annual before-tax cash flow: $4,000
- Depreciation expense (using MACRS): Year 1 = $10,000; Year 2 = $16,000; Year 3 = $9,600; Year 4 = $5,760; Year 5 = $2,880
- Annual after-tax cash flow (years 1-5): $4,000 x 0.6 (tax rate) = $2,400
- Salvage value: $0

Using a financial calculator or Excel, we can calculate the NPV for the new oven as:
- $2,400 x (1 - 1/1.1^5) / 0.1 = $8,608.16
- -$25,000 + $8,608.16 = -$16,391.84

Therefore, the NPV of the new oven is -$16,391.84. This means that purchasing the new oven will result in a negative NPV, and therefore, it is not the best choice. Keeping the old oven is the best choice.