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Developing Relevant Cash Flows for Part-Time Student Company’s Machine Renewal or Replacement Decision Mclovin, chief financial...

Developing Relevant Cash Flows for Part-Time Student Company’s Machine Renewal or Replacement Decision

Mclovin, chief financial officer of Part-Time Student Company (PTSC), 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

Mclovin is beginning to develop the relevant cash flows needed to analyze whether to renew or replace PTSC’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. Mclovin 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 11% ; the marginal tax rate is 40%.

Find the NPV, IRR, MIRR, payback and discounted payback for both alternatives. Which alternative should be selected? Explain.





Solutions

Expert Solution

Based on the given data, pls find below calculations:

Ans: Based on the above calculations, from IRR perspetive, option for going for renwal is better; However, since the CFO is determined to have higher profits than expected cash flows (NPV of $712659 above), it is receommeded to choose second option of going for new machine, which has higher NPV than that of the option for renewal of existing machine. Payback period and others are almost same for both these options.

Computations:

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of MIRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%, reinvestment factor%); Here, both discounting factor % and reinvestment factor% are considered same.

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Pay Back Period: Here, the period is computed for each project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.

For discounted Pay Back Period, instead of normal cash flows, discounted cash flows are considered.


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