Developing Relevant Cash Flows for Newman Upholstery

Company$$s Machine Renewal or Replacement Decision

Cosmo Kramer, chief financial officer of Newman Upholstery Company, 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$

Cosmo is beginning to develop the relevant cash flows needed to analyze whether to renew or

replace Newman$$s only depreciable asset, a machine that originally cost $$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, the existing machine can be sold

to net $$2,000$ before taxes. Cosmo 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 is $10\%.$ The marginal tax rate for Newman is $40\%.$