Crackle and Pop Telephone Company is considering an upgrade to their current call-waiting equipment. Their existing hardware was purchased 3 years ago for $150,000, has been depreciated straight line over a 5-year useful life (so, two years of depreciable life are remaining), and has an estimated current market value of $70,000. Bob Crackle (owner of the firm) estimates that the current equipment could probably last 5 more years (from today) at which time its market value will equal $0.
A replacement piece of equipment costs $300,000, and can be depreciated straight line over 3 years. This new equipment will last 5 years, at which time its market (scrap) value will equal $10,000. Due to enhanced features, acquiring this new equipment would lead to a $10,000 revenue increase in the first year (t=1). These revenues would grow by $4,000 per year for the subsequent four years (t = 2, 3, 4, 5). (So, revenues will be $10,000, $14,000, 18,000….. higher.) In addition, due to its higher quality construction, it would lead to a decrease in operating expenses of $7,000 per year at times t =1,2,3,4, and 5. (So, expenses are lower by $7,000, $7,000, $7,000….)
Due to the increase in revenues, accounts receivable will likely rise. Mr. Crackle estimate that AR will go from the exiting level of $12,000 to $18,000 at time 1, $20,000 at times 2, 3, and 4, and back to $12,000 at time 5.
If the required return for this type of project is 12% and the tax rate is 40%, should the replacement piece of equipment be acquired? Be sure to provide quantitative justification for your answer.