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a. Calculate the initial investment associated with each of Clark Upholsterys alternatives.

b. Calculate the incremental operating cash inflows associated with each of Clarks alternatives.

c. Calculate the terminal cash flow at the end of year 5 associated with each of Clarks alternatives.

d. Use your findings in parts a, b, and c to depict on a time line the relevant cash flows associated with each of Clark Upholsterys alternatives.

e. Solely on the basis of your comparison of their relevant cash flows, which alternative appears to be better? Why?

Bo Humphries, chief financial officer of Clark Upholstery Company, expects the firms net operating profit after taxes for the next 5 years to be as shown in the following table.

1 $100,000

2 150,000

3 200,000

4 250,000

5.. 320,000

Bo is beginning to develop the relevant cash flows needed to analyze whether to renew or replace Clarks 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. (Because the firms only depreciable asset is fully depreciatedits book value is zero its expected operating cash inflows equal its net operating profit after taxes.) 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 and interest):

.:.

The renewed machine would result in art 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-year recovery periods. The firms projected revenues and expenses (excluding depreciation and interest), if it acquires the machine, would be as follows:

.:.

The new machine would result in an increased investment in net working capital of $22,000. At the end of 5 years, the new machine could be sold to net $25,000 before taxes. The firm is subject to a 40% tax rate. As noted, the company uses MACRS depreciation.

Initial Investment:

Alternative 1 Alternative 2

Installed cost of new asset

Cost of asset

+Installation costs 0

Total proceeds, sale of new asset

- After-tax proceeds from sale of old asset

Proceeds from sale of old asset 0

+Tax on sale of old asset* 0

Total proceeds, sale of old asset 0

+Change in working capital

Initial investment $

Calculation of Operating Cash Inflows
Year	Profits before Depreciation and Taxes	Depreciation	NetProfits before Taxes	Taxes	NetProfits after Taxes	Operating Cash Inflows
Alternative 1
1
2
3
4
5
6
Alternative 2
1
2
3
4
5
6

C.

Terminal Cash Flow:

Alternative 1 Alternative 2

After-tax proceeds from

sale of new asset =

Proceeds from sale of new asset

-Tax on sale of new asset^l

Total proceeds, sale of new asset

- After-tax proceeds from sale of old asset =

Proceeds from sale of old asset

+Tax on sale of old asset²

Total proceeds, sale of old asset

+Change in working capital

Terminal cash flow

Book value of Alternative 1 at end of Year 5: =

Book value of old asset at end of Year 5: =

Alternative 1

Year 5 relevant cash flow: Operating cash flow:

Terminal cash flow Total cash inflow

Alternative 2

Year 5 relevant cash flow: Operating cash flow:

Terminal cash flow Total cash inflow

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