Principles of Managerial Finance

CHAPTER 8 Capital Budgeting Cash Flows 391

CHAPTER 8 CASE Developing Relevant Cash Flows for Clark Upholstery

Company’s Machine Renewal or Replacement Decision

B

o Humphries, chief financial officer of Clark Upholstery Company, expects

the firm’s net profits after taxesfor the next 5 years to be as shown in the

following table.

Bo is beginning to develop the relevant cash flows needed to analyze

whether to renew or replace Clark’s onlydepreciable asset, a machine that origi-

nally 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. Bo 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 would be depreciated

under MACRS using a 5-year recovery period. Renewing the machine would

result in the following projected revenues and expenses (excluding depreciation):

The renewed machine would result in an increased investment in net working

capital of $15,000. 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 that costs

$100,000 and requires installation costs of $10,000. The new machine would

have a 5-year usable life and would be depreciated under MACRS using a 5-

Expenses

Year Revenue (excl. 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

Year Net profits after taxes

1 $100,000

2 150,000

3 200,000

4 250,000

5 320,000