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Bo Humphries, chief financial officer of Clark upholstery company ...

By David Hawkins,2014-11-28 12:59
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Bo Humphries, chief financial officer of Clark upholstery company ...

    Bo Humphries, chief financial officer of Clark upholstery company, expects the firm’s net operation profit after taxes for the next 5 years to be as shown in the following table. Year Net operating profit 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 asses, 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

    operating cash inflows equal its net operating profit after taxes.) 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 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 and interest): Year Revenue Expenses (excl. depr, and int.) 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 cost $100,000 and requires installation cost 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 and interest), if it acquires the machine, would be as follows: Year Revenue Expenses (excl. depr, and int.) 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 would be sold to net $25,000 before taxes. The firm is subject to a 40% tax rate. As noted, the company uses MACRS depreciation. Question: 1. Calculate the initial investment associated with each of Clark Upholstery’s alternatives. 2. Calculate the incremental operating cash inflows associated with each of Clark’s alternatives. (Note: Be sure to consider the depreciation in year 6) 3. Calculate

    the terminal cash flow at the end of year 5 associated with each of Clark’s alternatives. 4. Use the findings in question 1, 2, and 3 to depict on a time line the relevant cash flows associated with each of Clark Upholstery’s alternatives. 5. Solely on the basis of the

    comparison of their relevant cash flows, which alternative appears to be better? Why?

(a) Initial Investment

     Alternative 1 Alternative 2

     Installed cost of new asset

     Cost of asset $90,000 $100,000

     Installation costs 0 10,000

     Total proceeds, sale of new asset 90,000 110,000 After-tax proceeds from sale of old asset

     Proceeds from sale of old asset 0 (20,000)

    * Tax on sale of old asset 0 8,000

     Total proceeds, sale of old asset 0 (12,000) Change in working capital 15,000 22,000 Initial investment $105,000 $120,000 * Book value of old asset 0

     $20,000 $0 $20,000 recaptured depreciation

     $20,000 (0.40) $8,000 tax

    (b)

    Calculation of Operating Cash Inflows

    Profits

    Before Net Profits Operating

    Depreciation Depre-Before Net Profits Cash

    Year and Taxes ciation Taxes Taxes After Taxes Inflows Alternative 1

    1 $198,500 $18,000 $180,500 $72,200 $108,300 $126,300

    2 290,800 28,800 262,000 104,800 157,200 186,000

    3 381,900 17,100 364,800 145,920 218,880 235,980

    4 481,900 10,800 471,100 188,440 282,660 293,460

    5 581,900 10,800 571,100 228,440 342,660 353,460

    6 0 4,500 1,800 4,500 1,800 2,700 Alternative 2

    1 $235,500 $22,000 $213,500 $85,400 $128,100 $150,100

    2 335,200 35,200 300,000 120,000 180,000 215,200

    3 385,100 20,900 364,200 145,680 218,520 239,420

    4 435,100 13,200 421,900 168,760 253,140 266,340

    5 551,100 13,200 537,900 215,160 322,740 335,940

    6 0 5,500 2,200 5,500 2,200 3,300

    Calculation of Incremental Cash Inflows

     Incremental Cash

    Flow Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2 1 $126,300 $150,100 $100,000 $26,300 $50,100 2 186,000 215,200 150,000 36,000 65,200 3 235,980 239,420 200,000 35,980 39,420 4 293,460 266,340 250,000 43,460 16,340 5 353,460 335,940 320,000 33,460 15,940 6 1,800 2,200 0 1,800 2,200

(c) Terminal Cash Flow:

     Alternative 1 Alternative 2 After-tax proceeds from

     sale of new asset

     Proceeds from sale of new asset $8,000 $25,000

    l Tax on sale of new asset (1,400) (7,800)

     Total proceeds, sale of new asset 6,600 17,200 ;;? After-tax proceeds from sale of old asset

     Proceeds from sale of old asset (2,000) (2,000)

    2 Tax on sale of old asset 800 800

     Total proceeds, sale of old asset (1,200) (1,200) Change in working capital 15,000 22,000 Terminal cash flow $20,400 $38,000

    1 Book value of Alternative 1 at end of year 5: $4,500

     $8,000 $4,500 $3,500 recaptured depreciation

     $3,500 (0.40) $1,400 tax

     Book value of Alternative 2 at end of year 5: $5,500

     $25,000 $5,500 $19,500 recaptured depreciation

     $19,500 (0.40) $7,800 tax

    2 Book value of old asset at end of year 5: $0

     $2,000 $0 $2,000 recaptured depreciation

     $2,000 (0.40) $800 tax

    Alternative 1

    Year 5 Relevant Cash Flow: Operating Cash Flow: $33,460

     Terminal Cash Flow 20,400

     Total Cash Inflow $53,860

    Alternative 2

    Year 5 Relevant Cash Flow: Operating Cash Flow: $15,940

     Terminal Cash Flow 38,000

     Total Cash Inflow $53,940

(d) Alternative 1

    Cash Flows

    $105,000 $26,300 $35,980 $43,460 $33,460 $53,860

     $1,800

     | | | | | | |

    0 1 2 3 4 5 6

    End of Year

     Alternative 2

    Cash Flows

    $120,000 $50,100 $65,200 $39,420 $16,340 $53,940 $2,200

     | | | | | | |

    0 1 2 3 4 5 6

    End of Year

    (e) Alternative 2 appears to be slightly better because it has the larger incremental

    cash flow amounts in the early years.

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