Reference no: EM133068182

Question - Smith Inc. owns an industrial furnace which it bought for $5,000,000. The furnace had an estimated useful life of 8 years and a salvage value of $150,000. The furnace has been in service for 5 years and Smith Inc. has depreciated the furnace using the straight-line method (as a result, the balance in accumulated depreciation is $3,031,250). Smith Inc. is considering replacing the old furnace with a new furnace. If Smith Inc. disposes of the old furnace, it will be able to sell the old furnace for $2,000,000 but the company will have to pay shipping costs of $12,000 in order to get rid of the old furnace.

The new furnace would cost Smith Inc. $6,000,000. In addition, Smith Inc. will have to pay a delivery fee of $6,000 and installation charges of $4,000. The new furnace is expected to produce annual operating revenues of $2,000,000 and incur $400,000 in annual operating expenditures. Smith Inc. will also incur annual non-tax deductible environmental impact fees of $5,000. In the first year of operation of the new furnace, Smith Inc. will have to train employees on the new furnace at a cost of $35,000. Due to high employee turnover, Smith Inc. will again incur this training cost in year 3 of operating the new furnace.

Additional Information - For financial accounting and tax purposes Smith Inc. will depreciate the new furnace using the straight-line method of depreciation. The estimated useful life is 6 years and the salvage value for depreciation is estimated to be $40,000.

Smith Inc. estimates they will be able to sell the new furnace at the end of its useful life for $20,000.

Smith Inc. operates in a 30% tax-bracket for the entire period.

Management at Smith Inc. requires an 8 % return on all new investments.

Required -

1. Calculate the NPV of the proposed investment in the new furnace. Should Smith Inc. go ahead with the project?

2. Calculate the payback period for the proposed investment described above.

3. Discuss how the NPV of the project would change if management's required rate of return was higher than 8%? Similarly, what if management's required rate of return was below 8%?

4. Discuss how the use of an accelerated depreciation method instead of the straight-line method would affect the NPV of any proposed capital investment?