Assess initial investment associated with each alternative

QUESTION: CLEARAWAY UPHOLSTERY LIMITED

Question 1: Calculate the initial investment associated with each alternative.

Question 2: Calculate the incremental operating net cash inflows associated with each alternative.

Question 3: Calculate the terminal cash flow at the end of five years associated with each alternative.

Question 4: Make a recommendation presenting the most favourable option to Clearaway Upholstery Limited.

Case Scenario:

Jason Humphries, chief financial officer of Clearaway Upholstery Limited, expects the firm's net profits after taxes for the next five years to be as shown in the following table:

 Year Net profits after taxes 1 2 3 4 5 \$100,000 \$150,000 \$200,000 \$250,000 \$320,000

Jason is developing the relevant cash flow calculations needed to analyse whether to renew or replace Clearaway's only depreciable asset, a machine originally costing \$30,000, having a current book value of \$0, and that can 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 net cash inflows.]  Estimates are that at the end of five years the existing machine can be sold to net \$2000 before taxes.  The company tax rate is 30%. The company uses the straight-line depreciation method.  Two alternatives are being considered and are independently outlined below.

Alternative One:

Renew the existing machine at a total depreciable cost of \$90,000.  The renewed machine would have a five-year useable life and be depreciated using the straight-line method over an effective life of five years.  Renewing the machine would result in the following projected revenues and expenses (excluding depreciation):

 Year Revenue Expenses (excluding depreciation) 1 2 3 4 5 \$1,000,000 \$1,175,000 \$1,300,000 \$1,425,000 \$1,550,000 \$801,500 \$884,200 \$918,100 \$943,100 \$968,100

The renewed machine would result in an increase of \$15,000 in net working capital.  At the end of five years, the machine could be sold to net \$8000 before taxes.

Alternative Two:

Replace the existing machine with a new machine costing \$100,000 and requiring installation costs of \$10,000.  The new machine would have a five-year useable life and be depreciated using the straight-line method over an effective life of five years.  The firm's projected revenues and expenses (excluding depreciation), if it acquires the machine, are as follows:

 Year Revenue Expenses (excluding depreciation) 1 2 3 4 5 \$1,000,000 \$1,175,000 \$1,300,000 \$1,425,000 \$1,550,000 \$764,500 \$839,800 \$914,900 \$989,900 \$998,900

The new machine would result in an increase of \$22,000 in net working capital.  At the end of five years, the new machine could be sold to net \$25,000 before taxes.  The company is subject to an income tax rate of 30 percent on both ordinary income and capital gains. Assume the risk of each alternative is similar to that of the company. The company cost of capital is 10%.

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