Max Chips is a manufacturer of prototype chips based in Buffalo, New York. Next year, in 2018,

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Question:

Max Chips is a manufacturer of prototype chips based in Buffalo, New York.

Next year, in 2018, Max Chips expects to deliver 555 prototype chips at an average price of $90,000. Max Chips' marketing vice president forecasts growth of 55 prototype chips per year through 2014. That is, demand will be 610 in 2018, 665 in 2019, 720 in 2020, and so on.

The plant cannot produce more than 595 prototype chips annually. To meet future demand, Max Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $4,400,000 if the plant is replaced. If the plant is modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the updated plant. The old equipment is retained as part of the modernize alternative.

The following data on the two options are available:

	Modernize	Replace
Initial investment in 2018	$34,400,000	$66,100,000
Terminal disposal value in 2024	$7,400,000	$17,200,000
Useful life	7 years	7 years
Total annual cash operating cost per prototype chip	$75,000	$64,000

Max Chips uses straightline depreciation, assuming zero terminal disposal value. For simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2018, and all transactions thereafter occur on the last day of the year. Max Chips' required rate of return is 12%. There is no difference between the modernize and replace alternatives in terms of required working capital. Max Chips pays a 40% tax rate on all income. Proceeds from sales of equipment above book value are taxed at the same 40% rate.

Questions:

1.Calculate the after-tax cash inflows and outflows of the modernize and replace alternatives over the 2018 -2014 period.

2.Calculate the net present value of the modernize and replace alternatives.

3.Suppose Max Chips is planning to build several more plants. It wants to have the most advantageous tax position possible. Max Chips has been approached by Spain, Malaysia, and Australia to construct plants in their countries. Briefly describe in qualitative terms the income tax features that would be advantageous to Max Chips.