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