Bo Humphries, chief financial officer of Clark upholstery company, expects the firms net operation profit after taxes for the

Bo Humphries, chief financial officer of Clark upholstery company, expects the firms 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 Clarks 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 firms 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 firms 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 Upholsterys alternatives. 2. Calculate the incremental operating cash inflows associated with each of Clarks 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 Clarks 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 Upholsterys 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 1Alternative 2

Installed cost of new asset

Cost of asset$90,000

$100,000

Installation costs0

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 asset0

(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

YearProfits BeforeDepreciationand TaxesDepre-ciationNet ProfitsBefore TaxesTaxesNet ProfitsAfter TaxesOperatingCashInflows

Alternative 1

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

2290,80028,800262,000104,800157,200186,000

3381,90017,100364,800145,920218,880235,980

4481,90010,800471,100188,440282,660293,460

5581,90010,800571,100228,440342,660353,460

604,5004,5001,8002,7001,800

Alternative 2

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

2335,20035,200300,000120,000180,000215,200

3385,10020,900364,200145,680218,520239,420

4435,10013,200421,900168,760253,140266,340

5551,10013,200537,900215,160322,740335,940

605,5005,5002,2003,3002,200

Calculation of Incremental Cash Inflows

Incremental Cash Flow

YearAlternative 1Alternative 2ExistingAlt. 1Alt. 2

1$126,300$150,100$100,000$26,300$50,100

2186,000215,200150,00036,00065,200

3235,980239,420200,00035,98039,420

4293,460266,340250,00043,46016,340

5353,460335,940320,00033,46015,940

61,8002,20001,8002,200

(c)Terminal Cash Flow:

Alternative 1Alternative 2

After-tax proceeds from

sale of new asset

Proceeds from sale of new asset$8,000

$25,000

Tax on sale of new assetl(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)

Tax on sale of old asset2800

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

1Book 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

2Book 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 Flow20,400

Total Cash Inflow$53,860

Alternative 2

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

Terminal Cash Flow38,000

Total Cash Inflow$53,940

(d)Alternative 1Cash Flows

$105,000$26,300$35,980$43,460$33,460$53,860$1,800

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Alternative 2

Cash Flows

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

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(e)Alternative 2 appears to be slightly better because it has the larger incremental cash flow amounts in the early years.