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) InitialInvestment
Alternative1
Installedcostofnewasset
Costofasset
$90,000
Installationcosts
0
Totalproceeds,saleofnewasset
90,000
110,000
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset
0
*
Taxonsaleofoldasset
0
Totalproceeds,saleofoldasset
0
(12,000)
Changeinworkingcapital
15,000
Initialinvestment
$105,000
$120,000
*

Bookvalueofoldasset
0
$20,000$0
$20,000recaptureddepreciation
$20,000(0.40) $8,000tax

Alternative2
$100,000
10,000

(20,000)
8,000

22,000

(b)
CalculationofOperatingCashInflows
Profits
Before
Depreciation
andTaxes

Year

Depre
ciation

NetProfits
Before
Taxes

Operating
NetProfits
Cash
Taxes AfterTaxes Inflows

Alternative1
1

$198,500

$18,000

$180,500

$72,200 $108,300

$126,300

290,800

28,800

262,000

104,800

157,200

186,000

381,900

17,100

364,800

145,920

218,880

235,980

481,900

10,800

471,100

188,440

282,660

293,460

581,900

10,800

571,100

228,440

342,660

353,460

4,500

4,500

1,800

2,700

1,800

$235,500

$22,000

$213,500

$85,400 $128,100

$150,100

335,200

35,200

300,000

120,000

180,000

215,200

385,100

20,900

364,200

145,680

218,520

239,420

435,100

13,200

421,900

168,760

253,140

266,340

551,100

13,200

537,900

215,160

322,740

335,940

5,500

5,500

2,200

3,300

2,200

Alternative2

CalculationofIncrementalCashInflows
IncrementalCash
Flow
Year

Alternative1

Alternative2

Existing

Alt.1

Alt.2

$126,300

$150,100

$100,000

$26,300

$50,100

186,000

215,200

150,000

36,000

65,200

235,980

239,420

200,000

35,980

39,420

293,460

266,340

250,000

43,460

16,340

353,460

335,940

320,000

33,460

15,940

1,800

2,200

1,800

2,200

(c) TerminalCashFlow:
Alternative1
Aftertaxproceedsfrom
saleofnewasset
Proceedsfromsaleofnewasset
$8,000
Taxonsaleofnewassetl
(1,400)
Totalproceeds,saleofnewasset
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset
(2,000)
Taxonsaleofoldasset2
800
Totalproceeds,saleofoldasset
Changeinworkingcapital
Terminalcashflow
1

Alternative2

$25,000
(7,800)
6,600

17,200
(2,000)
800

(1,200)
15,000
$20,400

BookvalueofAlternative1atendofyear5:
$4,500
$8,000$4,500
$3,500recaptureddepreciation
$3,500(0.40)
$1,400tax
BookvalueofAlternative2atendofyear5:
$5,500
$25,000$5,500
$19,500recaptureddepreciation
$19,500(0.40)
$7,800tax

Bookvalueofoldassetatendofyear5:

$2,000$0 $2,000recaptureddepreciation
$2,000(0.40)
$800tax

Alternative1
Year5RelevantCashFlow:

Alternative2
Year5RelevantCashFlow:

$0

OperatingCashFlow: $33,460
TerminalCashFlow
20,400
TotalCashInflow
$53,860
OperatingCashFlow: $15,940
TerminalCashFlow
38,000
TotalCashInflow
$53,940

(1,200)
22,000
$38,000

(d) Alternative1
CashFlows
$105,000
|
|
0

$26,300
$1,800
|

$35,980

1
6

$43,460

$33,460

$53,860

EndofYear
Alternative2
CashFlows
$120,000 $50,100
$2,200
|
|
|
0
1
6

$65,200

$39,420

$16,340

$53,940

EndofYear
(e) Alternative2appearstobeslightlybetterbecauseithasthelargerincremental
cashflowamountsintheearlyyears.