Developing Relevant Cash Flows for Clark Upholstery Company’s Machine Renewal or Replacement…

Developing Relevant Cash Flows for Clark Upholstery Company’s Machine Renewal or Replacement Decision

Bo Humphries, chief financial officer of Clark Upholstery Company, expects the firm’s net profits after taxes for the next 5 years to be as shown in the following table.

 

 

Year

Net profits after taxes

1

$100,000

2

150,000

3

200,000

4

250,000

5

320,000

Bo is beginning to develop the relevant cash flows needed to analyze whether to renew or replace Clark’s only depreciable asset, a machine that originally cost $30,000, has a current book value of zero, and can now be sold for $20,000. (Note: Because the firm’s only depreciable asset is fully depreciated— its book value is zero—its expected net profits after taxes equal its operating cash inflows.) He estimates that at the end of 5 years, the existing machine can be sold to net $2,000 before taxes. Bo plans to use the following information to develop the relevant cash flows for each of the alternatives.

Alternative 1 Renew the existing machine at a total depreciable cost of $90,000. The renewed machine would have a 5-year usable life and would be depreciated under MACRS using a 5-year recovery period. Renewing the machine would result in the following projected revenues and expenses (excluding depreciation):

Expenses

Year

Revenue

(excl. depreciation)

1

$1,000,000

$801,500

2

1,175,000

884,200

3

1,300,000

918,100

4

1,425,000

943,100

5

1,550,000

968,100

The renewed machine would result in an increased investment in net working capital of $15,000. At the end of 5 years, the machine could be sold to net $8,000 before taxes.

Alternative 2 Replace the existing machine with a new machine that costs $100,000 and requires installation costs of $10,000. The new machine would have a 5-year usable life and would be depreciated under MACRS using a 5- year recovery period. The firm’s projected revenues and expenses (excluding depreciation), if it acquires the machine, would be as follows:

Expenses

Year

Revenue

(excl. depreciation)

1

$1,000,000

$764,500

2

1,175,000

839,800

3

1,300,000

914,900

4

1,425,000

989,900

5

1,550,000

998,900

The new machine would result in an increased investment in net working capital of $22,000. At the end of 5 years, the new machine could be sold to net $25,000 before taxes. The firm is subject to a 40% tax on both ordinary income and capital gains. As noted, the company uses MACRS depreciation. (See Table 3.2 on page 100 for the applicable depreciation percentages.)

Required

a. Calculate the initial investment associated with each of Clark Upholstery’s alternatives.

b. Calculate the incremental operating cash inflows associated with each of Clark’s alternatives. (Note: Be sure to consider the depreciation in year 6.)

c. Calculate the terminal cash flow at the end of year 5 associated with each of Clark’s alternatives.

d. Use your findings in parts a, b, and c to depict on a time line the relevant cash flows associated with each of Clark Upholstery’s alternatives.

e. Solely on the basis of your comparison of their relevant cash flows, which alternative appears to be better? Why?

TABLE 3.2

Rounded Depreciation

Percentages by Recovery Year

Using MACRS for First Four

Property Classes

Percentage by recovery yeara
Recovery year 3 years 5 years 7 years 10 years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 ___ ___ ___ 4
Totals 100% 100% 100% 100%

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