Developing Relevant Cash Flows for Part-Time Student

Companys Machine Renewal or Replacement Decision

Mclovin, chief financial officer of Part-Time Student Company (PTSC), expects the firms 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 PTSCs 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 firms 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 firms 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% and the marginal tax rate is 40%.

Find the NPV, IRR, MIRR, payback and discounted payback for both alternatives. Which alternative should be selected? Explain.