Case Scenario:
Gordon is a high-technology company that manufactures sophisticated testing instruments for evaluating microcircuits. These instruments sell for $3,500 each and cost $2,450 each to manufacture. An essential component of the company’s manufacturing process is a sealed vacuum chamber where the interior approaches a pure vacuum. The technology of the vacuum pumps that the firm uses to prepare its chamber for sealing has been changing rapidly. On January 2, 2006, Gordon bought the latest in electronic high-speed vacuum pumps, a machine that allowed the company to evacuate a chamber for sealing in only six hours. The company paid $400,000 for the pump. Recently, the manufacturer of the pump approached Gordon with a new pump that would reduce the evacuation time to two hours. The Management team is considering the acquisition of this new pump and has asked the controller to evaluate the financial impact of replacing the existing pump with the new model. The controller gathered the following information prior to preparing her analysis.
• The new pump would be installed on December 31, 2008 and place in service January 1, 2009. The cost of the pump is $608,000, and the cost for installing, testing, and debugging the new pump will be $12,000. For depreciation purposes, these costs will be considered part of the cost of the equipment. The pump has a 3 year useful life and is expected to have a salvage value of $80,000 when sold at the end of four years. Gordon uses straight-line depreciation.
• The old pump will be fully depreciated at the time the new pump is place in service. If the new pump is purchased. Arrangements will be made to sell the old pump for $50,000, the estimated salvage value on December 31, 2008.
• At the current rate of production, the new pump’s greater efficiency will result in annual cash savings of $125,000.
• Gordon is able to sell all of the testing instruments it can produce. Because of the increased speed of the new pump, output is expected to be 30 units greater in 2009 than in 2008. In 2010 and 2011, production will be 50 units greater than in 2008. The production in 2012 will exceed 2008 by 70 units. For all additional units produced, the manufacturing costs would be reduced by $150 per unit.
• For evaluating capital investment proposals, Gordon’s management uses a 16% after-tax discount rate. Ignore Taxes.
Required:
1. Determine whether or not Gordon should purchase the new pump by calculating the net present value of the investment.