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
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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 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.
Sample Solution