Reference no: EM133380037
Developing Relevant Cash Flows for Newman Upholstery
Company's Machine Renewal or Replacement Decision
Cosmo Kramer, chief financial officer of Newman 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 |
| |
|
Cosmo is beginning to develop the relevant cash flows needed to analyze whether to renew or replace Newman'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. Cosmo 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 depreciated under MACRS using a 5-year recovery period. Renewing the machine would result in the following projected revenues and expenses (excluding depreciation):
| Year |
Revenue |
Expenses
(excluding 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 of $15,000 in net working capital. 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 costing $100,000 and requiring installation costs of $10,000. The new machine would have a 5-year usable life and 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:
| Year |
Revenue |
Expenses(excluding 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 of $22,000 in net working capital. At the end of 5 years, the new machine could be sold to net $25,000 before taxes. The weighted average cost of capital is 10%. The marginal tax rate for Newman is 40%.
Find the NPV, IRR, MIRR, payback and discounted payback for both alternatives. Which alternative should be selected? Explain.