Question

The Riley Corporation is considering whether or not to introduce a modified version of one of its products, Newones. The product would replace an existing product, Oldones. The product line has an estimated life of four years, regardless of which product the firm sells. The following information has been collected to help in making this decision.

• Sales of Newones is expected to be $165,000 per year in each of the next four years; manufacturing expenses will be $57,000 per year. For Oldones, expected sales would be $80,000 per year and manufacturing expenses would be $35,000 per year.
• Advertising and marketing expenses of $15,000 per year in each of the next four years would be expected if Oldones were produced. If Newones were introduced, an initial (year 0) outlay of $18,000 for advertising and promotion would be required in addition to annual expenditures of $25,000 per year for the next four years. A marketing study costing $15,000 was used to determine expected sales of Newones last year.
• The machinery that would be used to produce Oldones originally cost $140,000. It currently has a book value of $100,000. Annual depreciation of $20,000 will be charged if the machine is kept. The old machine could be sold now for $80,000 or sold after four years for $5,000.
• To produce Newones, a new machine costing $200,000 would be required. The new machine would be depreciated on a straight-line basis to zero salvage value over its expected economic life of five years. However, the machine would be sold for an estimated $50,000 after four years.
• The firm’s marginal tax rate is 30%; the firm’s cost of capital is 15%.

Should the firm replace Oldones with Newones? Show your work.

Answer 1

Cashflow calculation for both the options are:

Since the Present value of cashflows at year 0 for oldones ($77084.416) is higher than the cashflows for Newones ($42742.749), the firm shpouldnot replace the oldones with new ones.

Here, Present value for future cashflows is calculated by = A*(1+R)^t where, t= time period R=15%, A= cashflow from operations each year

Present value for past cashflows = A/(1+R)^t where t= time period R=15%, A= cashflow from operations each year