Question

Case 1: International Automotive Assembly Company – U.S. Automotive Inc. International Automotive (IA) Company is a manufacturer and distributor of large assembly machinery for the automotive industry. The firm’s customers include seven of the top ten auto makers (by total annual units) in the world. The auto makers are continually searching for more advanced technological solutions to cut long-term costs and increase efficiency. One such company, U.S. Automotive (USA) Inc., has been in discussions with IA about replacing one of its welding robots with a more advanced model. IA’s sales manager has proposed two cash purchase alternatives for USA’s consideration. Both would speed up welding times and reduce labor costs since fewer change-overs and maintenance would be required. Key financial data for the old robot and the two proposed alternatives are summarized below.

Old robot: Originally purchased 3 years ago at an installed cost of 425,000, it is being depreciated under the MACRS 5-year schedule. It’s remaining economic life is 5 years. The robot can be sold now for $445,000 before taxes. If retained instead, it can be sold at the end of 5 years to net $160,000 before taxes.

Robot X: The more advanced of the two recommended alternatives, it can be purchased for $790,000 and will require $30,000 of installation costs. The 5-year MACRS depreciation schedule will be used. At the end of 5 years it’s estimated the machine could be sold to net $380,000 before taxes. Current account changes associated with the acquisition of this robot are listed in the table below.

Cash $ 20,000, Accounts receivable $ 100,000, Inventory $ (22,600), Accounts payable $ 31,000,

Robot Y: Purchase cost is $600,000 and installation cost is $25,000. The same 5-year MACRS depreciation schedule will be used. At the end of 5 years, the robot can be sold to net $290,000 before taxes. No effect on the firm’s current accounts is expected. Not for distribution or posting outside of this course.

Estimated earnings before depreciation and taxes for each of the three robots (old, X and Y) over the next 5 years is shown in the table below. USA is subject to a corporate tax rate of 21% and cost of capital of 13%.

EBDT for U.S. Automotive Inc. robot scenarios Year Old Robot ($) Robot X ($) Robot Y ($) 1         115,000          240,000         199,000 2         115,000          280,000         199,000 3         115,000         290,000         199,000 4         115,000         320,000         199,000 5         115,000         340,000         199,000

For each of the two proposed replacement robots, calculate:

A. Initial investment

B. Operating cash inflows and Incremental cash inflows

C. Terminal cash flow

2) Based on the data from question #1, depict in both table and timeline format the relevant cash

flow stream for Robot X and Robot Y, assuming each is terminated at the end of year 5.

3) Calculate for the new robot alternatives each of the following decision methods.

A. Payback period

B. NPV

C. IRR

4) Recommend which, if either, of the new robots USA should acquire if the firm has

A. unlimited funds

B. capital rationing

5) Assuming the cash inflows associated with Robot X are considered significantly riskier than

Robot Y, how does this impact your recommendation in question #4

5-year MACRS Depreciation
Yr 1	20%
Yr 2	32%
Yr 3	19%
Yr 4	12%
Yr 5	12%
Yr 6	5%

Answer 1

A - initial investment

Robot X - 820000 - 445000 = $3,75,000

Robot Y -625000 - 445000 = $1,80,000