Question

Crane Manufacturing management is considering overhauling their existing line, which currently has both a book value and a salvage value of $0. It would cost $280,000 to overhaul the existing line, but this expenditure would extend its useful life to five years. The line would have a $0 salvage value at the end of five years. The overhaul outlay would be capitalized and depreciated using MACRS over three years. The tax rate is 35 percent, the opportunity cost of capital is 12 percent. The NPV of the new production line is $-360,000.

Answer 1

Since the cost of the renovation or overhauling of the existing line would be recovered in Year 4 and the NPV of the new production line is $-360,000, Crane Manufacturing should renovate.

What is the difference between renovation and replacement?

Renovation restores an old asset to a better state.  Replacement rids the old in preference for a new asset.

When the two investment options are weighed, a better choice can be arrived at.

Data and Calculations:

MACRS - Three Years Depreciation:

Year 1 = $93,324 ($280,000 x 33.33%)

Year 2 = $124,460 ($280,000 x 44.45%)

Year 3 = $41,468 ($280,000 x 14.81%)

Year 4 = $20,748  ($280,000 x 7.41%)

Total cost = $280,000

NPV of new production line = $-360,000

Thus, based on the cost recovery of the old production line and the negative NPV of the new production line, Crane Manufacturing should renovate.

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Question Completion:

Should Crane replace or renovate the existing line?