Developing Relevant Cash Flows for Clark Upholstery? Company\'s Machine. Renewal
ID: 2618514 • Letter: D
Question
Developing Relevant Cash Flows for Clark Upholstery? Company's Machine. Renewal or Replacement Decision???
Bo? Humphries, chief financial officer of Clark Upholstery? Company, expects the? firm's net operating profit after taxes for the next 5 years to be as shown in the following table:
YEAR 1 net operating profit after taxes: $100,000
YEAR 2 net operating profit after taxes: $150,000
YEAR 3 net operating profit after taxes: $200,000
YEAR 4 net operating profit after taxes: $250,000
YEAR 5 net operating profit after taxes: $320,000
Bo is beginning to develop the relevant cash flows needed to analyze whether to renew or replace? Clark'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 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.
To Do
a. Calculate the initial investment associated with each of Clark? Upholstery's alternatives.
INITIAL INVESTMENT / ALTERNATIVE 1 / ALTERNATIVE 2
INSTALLED COST OF ASSET:
COST OF ASSET:
INSTALLATION COSTS:
TOTAL COST OF ASSET:
AFTER-TAX PROCEEDS FROM SALE OF OLD ASSET:
PROCEEDS FROM SALE OF OLD ASSET:
TAX ON SALE OF OLD ASSET:
TOTAL PROCEEDS, SALE OF OLD ASSET:
CHANGE IN WORKING CAPITAL:
INITIAL INVESTMENT:
b. Calculate the incremental operating cash inflows associated with each of? Clark's alternatives.? (Note: Be sure to consider the depreciation in year? 6.)
CALCULATION OF OPERATING CASH INFLOWS ALTERNATIVE 1
YEAR 1 / YEAR 2 / YEAR 3 / YEAR 4 / YEAR 5 / YEAR 6
PROFITS BEFORE DEPRECIATION AND TAXES:
LESS: DEPRECIATION
NET PROFITS BEFORE TAXES:
LESS: TAXES
NET PROFITS AFTER TAXES:
OPERATING CASH INFLOWS:
LESS: EXISTING OP CASH INFLOWS
INCREMENTAL CASH INFLOWS:
CALCULATION OF OPERATING CASH INFLOWS ALTERNATIVE 2
YEAR 1 / YEAR 2 / YEAR 3 / YEAR 4 / YEAR 5 / YEAR 6
PROFITS BEFORE DEPRECIATION AND TAXES:
LESS: DEPRECIATION
NET PROFITS BEFORE TAXES:
LESS: TAXES
NET PROFITS AFTER TAXES:
OPERATING CASH INFLOWS:
LESS: EXISTING OP CASH INFLOWS
INCREMENTAL CASH INFLOWS:
c. Calculate the terminal cash flow at the end of year 5 associated with each of? Clark's alternatives.
book value of alternative 1 at the end of year 5 will be:
book value = cost - accumulated depreciation
book value =
recaptured depreciation for alternative 1 will be:
recaptured depreciation = sale price - book value
recaptured depreciation =
taxes on the sale of the new asset for alternative 1 will be:
taxes = recaptured depreciation x tax rate
taxes =
book value of alternative 2 at the end of year 5 will be:
book value =
recaptured depreciation for alternative 2 will be:
recaptured depreciation =
taxes on the sale of the new asset for alternative 2 will be:
taxes =
taxes on the sale of the old asset will be:
taxes =
the calculation of the terminal cash flow at the end of year 5 associated with each of Clark's alternatives are shown below:
terminal cash flow / alternative 1 / alternative 2
after-tax proceeds from sale of asset:
proceeds from sale of asset:
tax on sale of asset:
total proceeds, sale of asset
after-tax proceeds from sale of old asset:
proceeds from sale of old asset:
tax on sale of old asset:
total proceeds, sale of old asset:
change in working capital:
terminal cash flow:
operating cash flow:
total cash inflow:
d. Use your findings in parts (a?), ?(b?), and (c?) to depict on a time line the relevant cash flows associated with each of Clark? Upholstery's alternatives.
the relevant cash flows associated with alternative 1 are:
year 0 cash flow:
year 1 cash flow:
year 2 cash flow:
year 3 cash flow:
year 4 cash flow:
year 5 cash flow:
year 6 cash flow: $0?
the relevant cash flows associated with alternative 2 are:
year 0 cash flow:
year 1 cash flow:
year 2 cash flow:
year 3 cash flow:
year 4 cash flow:
year 5 cash flow:
year 6 cash flow: $0?
e. Solely on the basis of your comparison of their relevant cash? flows, which alternative appears to be? better? Why?
EXAMPLE: Alternative 2 appears to be slightly better because it has the larger incremental cash flow amounts in the early years. Assuming a 8 percent discount? rate, the NPV of Alternative 1 is $79,766, while the NPV of Alternative 2 is $99,126. The IRR of Alternative? 2, 41.1%?, is also higher than the IRR of Alternative? 1, which is 32.7%.
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 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 4 $1,425,000 $1,000,000 801,500 $1,175,000 884,200 $1,300,000 918,100 Revenue Expenses (Excl. depreciation and interest) 943,100 968,100 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.Explanation / Answer
Alternative 1 Years 1 2 3 4 5 6 COST OF ASSET: ($90,000.00) INSTALLATION COSTS: Rate of tax 40% Increase In working capital ($15,000.00) Discounting rate 9% TOTAL COST OF ASSET ($105,000.00) Revenue $1,000,000.00 $1,175,000.00 $1,300,000.00 $1,425,000.00 $1,550,000.00 Expanses ($801,500.00) ($884,200.00) ($918,100.00) ($943,100.00) ($968,100.00) Sales of machine $8,000.00 Return of working capital $15,000.00 Net revenue Before tax $198,500.00 $290,800.00 $381,900.00 $481,900.00 $604,900.00 Tax ($79,400.00) ($116,320.00) ($152,760.00) ($192,760.00) ($241,960.00) Net revenue after tax $119,100.00 $174,480.00 $229,140.00 $289,140.00 $362,940.00 PV ( Net income) 109266.055 160073.3945 210220.1835 265266.055 332972.4771 NPV $972,798.17 Alternative 2 COST OF ASSET: ($100,000.00) INSTALLATION COSTS: ($10,000.00) AFTER-TAX PROCEEDS FROM SALE OF OLD ASSET $12,000.00 Increase In working capital ($22,000.00) TOTAL COST OF ASSET ($120,000.00) Revenue $1,000,000.00 $1,175,000.00 $1,300,000.00 $1,425,000.00 $1,550,000.00 Expanses ($764,500.00) ($839,800.00) ($914,900.00) ($989,900.00) ($998,900.00) Sales of machine $25,000.00 Return of working capital $22,000.00 Net revenue Before tax $235,500.00 $335,200.00 $385,100.00 $435,100.00 $598,100.00 Tax ($94,200.00) ($134,080.00) ($154,040.00) ($174,040.00) ($239,240.00) Net revenue after tax $141,300.00 $201,120.00 $231,060.00 $261,060.00 $358,860.00 PV ( Net income) 141300 201120 231060 261060 358860 NPV $1,073,400.00 Alternative 2 appears to be slightly better because it has the larger incremental cash flow amounts in the early years.at 8% discounting rate.
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