Question

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. 1 $100,000

2. 2 $150,000

3. 3 $200,000

4. 4 $250,000

5. 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):

Y ear

1 2 3 4 5

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 1 2 3 4 5

Revenue $1,000,000 1,175,000 1,300,000 1,425,000 1,550,000

Expenses(excluding depreciation) $764,500

839,800 914,900 989,900 998,900

Revenue

$1,000,000
1,175,000
1,300,000
1,425,000
1,550,000
The renewed machine would result in an increased investment of $15,000 in net working capital. At the end of 5 years, the machine

Expenses (excluding depreciation) $801,500

884,200 918,100 943,100 968,100

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 will be given to your group when you email me or provide the names of your group to me in class; the marginal tax rate is 40%.

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

11% as the weighted average cost

Answer 1

ALTERNATIVE 1

Capital Investment	90000
Investment in Working Capital	15000

Depreciation Schedule	1	2	3	4	5
Depreciation rate	20%	32%	19.20%	11.52%	11.52%
Depreciation amount	18000	28800	17280	10368	10368
Ending Book Value	72000	43200	25920	15552	5184

Salvage Value	8000
Book Value at the end of 5 years	5184
Tax on Capital Gains	1126
After-tax Salvage Value	6874
Corporate tax rate	40%

WACC

11%

ALTERNATIVE 1	0	1	2	3	4	5
1. Initial Cash Flow
Capital Investment	-90000
Working Capital	-15000
2. Operating Cash Flows
Revenue		1000000	1175000	1300000	1425000	1550000
Expenses		801500	884200	918100	943100	968100
PROFITS BEFORE DEPRECIATION AND TAXES:		198500	290800	381900	481900	581900
LESS: DEPRECIATION		18000	28800	17280	10368	10368
NET PROFITS BEFORE TAXES:		180500	262000	364620	471532	571532
LESS: TAXES		72200	104800	145848	188613	228613
NET PROFITS AFTER TAXES:		108300	157200	218772	282919	342919
OPERATING CASH INFLOWS:		126300	186000	236052	293287	353287
LESS: EXISTING OP CASH INFLOWS		100000	150000	200000	250000	320000
INCREMENTAL CASH INFLOWS:		26300	36000	36052	43287	33287
3. Terminal Cash flow
Working Capital						15000
After-tax Salvage Value						6874
Net Cash flow (1+2+3)	-105000	26300	36000	36052	43287	55161
Cumulative cash flows	-105000	-78700	-42700	-6648	36639	91800
PV (Cash Flows)	-105000	23694	29218	26361	28515	32735
Cumulative PV of cash flows	-105000	-81306	-52088	-25727	2788	35523
NPV	35523
IRR	22.22%
MIRR	17.66%
Payback (years)	3.15
Discounted Payback (years)	3.90

ALTERNATIVE 2

Initial Investment	Alternative 1	Alternative 2
INSTALLED COST OF ASSET
COST OF ASSET:	90000	100000
INSTALLATION COSTS:		10000
TOTAL COST OF ASSET:	90000	110000
AFTER-TAX PROCEEDS FROM SALE OF OLD ASSET
PROCEEDS FROM SALE OF OLD ASSET:	0	20000
TAX ON SALE OF OLD ASSET:	0	8000
TOTAL PROCEEDS, SALE OF OLD ASSET:	0	12000
CHANGE IN WORKING CAPITAL:	15000	22000
INITIAL INVESTMENT:	105000	120000

Capital Investment	110000
Investment in Working Capital	22000
Salvage Value	25000
Book Value at the end of 5 years	6336
Tax on Capital Gains	7466
After-tax Salvage Value	17534
Corporate tax rate	40%

Depreciation Schedule	1	2	3	4	5
Depreciation rate	20%	32%	19.20%	11.52%	11.52%
Depreciation amount	22000	35200	21120	12672	12672
Ending Book Value	88000	52800	31680	19008	6336

Terminal cash flow	Alternative 2
after-tax proceeds from sale of asset:
proceeds from sale of asset:	25000
tax on sale of asset:	7466
total proceeds, sale of asset	17534
after-tax proceeds from sale of old asset:
proceeds from sale of old asset:	20000
tax on sale of old asset:	8000
total proceeds, sale of old asset:	12000
change in working capital:	22000
terminal cash flow:	51534
operating cash flow:	34209
total cash inflow:	85743

	0	1	2	3	4	5
1. Initial Cash Flow
Capital Investment	-110000
Working Capital	-22000
After tax proceeds from sale of old asset	12000
2. Operating Cash Flows
Revenue		1000000	1175000	1300000	1425000	1550000
Expenses		801500	884200	918100	943100	968100
PROFITS BEFORE DEPRECIATION AND TAXES:		198500	290800	381900	481900	581900
LESS: DEPRECIATION		22000	35200	21120	12672	12672
NET PROFITS BEFORE TAXES:		176500	255600	360780	469228	569228
LESS: TAXES		70600	102240	144312	187691	227691
NET PROFITS AFTER TAXES:		105900	153360	216468	281537	341537
OPERATING CASH INFLOWS:		127900	188560	237588	294209	354209
LESS: EXISTING OP CASH INFLOWS		100000	150000	200000	250000	320000
INCREMENTAL CASH INFLOWS:		27900	38560	37588	44209	34209
3. Terminal Cash flow
Working Capital						22000
After-tax Salvage Value						17534
After tax proceeds from sale of old asset						12000
Net Cash flow (1+2+3)	-120000	27900	38560	37588	44209	85743
Cumulative cash flows	-120000	-92100	-53540	-15952	28257	114000
PV (Cash Flows)	-120000	25135	31296	27484	29122	50884
Cumulative PV of cash flows	-120000	-94865	-63569	-36085	-6963	43921
NPV	43921
IRR	22.38%
MIRR	18.14%
Payback (years)	3.36
Discounted Payback (years)	4.14

Basis the NPV, IRR, MIRR and Payback period analysis, we can conclude that replacing the old machine with a new one is a superior alternative to renewing the old one.