Comfy Corporation manufactures furniture in several divisions,including the patio furniture division. The manager of the patiofurniture division plans to retire in two years.
The manager receives a bonus based on the division’s ROI, which iscurrently 7%.
One of the machines that the patio furniture division uses tomanufacture the furniture is rather old,
and the manager must decide whether to replace it. The new machinewould cost $35,000 and would last
10 years. It would have no salvage value. The old machine is fullydepreciated and has no trade-in value.
Comfy uses straight-line depreciation for all assets. The newmachine, being new and more efficient, would
save the company $5,000 per year in cash operating costs. The onlydifference between cash flow and net
income is depreciation. The internal rate of return of the projectis approximately 7%. Comfy Corporation’s
weighted-average cost of capital is 5%. Comfy is not subject to anyincome taxes.
1. Should Comfy Corporation replace the machine? Why or whynot?
2. Assume that “investment” is defined as average net long-termassets (that is, after depreciation) during the year. Compute theproject’s ROI for each of its first five years. If the patiofurniture manager is
interested in maximizing his bonus, would he replace the machinebefore he retires? Why or why not?
3. What can Comfy do to entice the manager to replace the machinebefore retiring?