Question

Equipment replacement, no income taxes. Clean Chips is a manufacturer of prototype chips based in Dublin, Ireland. Next year, in 2015, Clean Chips expects to deliver 535 prototype chips at an average price of $55,000. Clean Chips’ marketing vice president forecasts growth of 65 prototype chips per year through 2021. That is, demand will be 535 in 2015, 600 in 2016, 665 in 2017, and so on.

The plant cannot produce more than 525 prototype chips annually. To meet future demand, Clean Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $4,300,000 if the plant is replaced. If the plant is modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the updated plant. The old equipment is retained as part of the modernize alternative. The following data on the two options are available:

	Modernize	Replace
Initial investment in 2015	$36,800,000	$61,700,000
Terminal disposal value in 2021	$7,000,000	$17,000,000
Useful life	7 years	7 years
Total annual cash operating costs per prototype chip	$35,500	$26,000

Clean Chips uses straight-line depreciation, assuming zero terminal disposal value. For simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2015, and all transactions thereafter occur on the last day of the year. Clean Chips’ required rate of return is 10%.

There is no difference between the modernize and replace alternatives in terms of required working capital. Clean Chips has a special waiver on income taxes until 2021.

1. Sketch the cash inflows and outflows of the modernize and replace alternatives over the 2015–2021 period.

2. Calculate payback period for the modernize and replace alternatives.

3. Calculate net present value of the modernize and replace alternatives.

4. What factors should Clean Chips consider in choosing between the alternatives?

			Net Cash		Total Present
	PV factor		Inflow		Value
Present value of net cash flows:
After-tax cash flows from operations:
Dec 31, 2015		x		=
Dec 31, 2016		x		=
Dec 31, 2017		x		=
Dec 31, 2018		x		=
Dec 31, 2019		x		=
Dec 31, 2020		x		=
Dec 31, 2021		x		=

Present value of after-tax cash flow from
sale of equipment		x		=
Present value of annuity of equal income tax
cash savings from annual depreciation		x		=
Net initial investment
Net present value

Answer 1

ANSWER

AS per the given question,

Modernize --Year-wise cash inflows
	Sale price	Operating costs	Net Income	Forecasted Demand	Total cash inflow
Year 1-2015	55000	35500	19500	535	10432500
Year 2-2016	55000	35500	19500	600	11700000
Year 3-2017	55000	35500	19500	665	12967500
Year 4-2018	55000	35500	19500	730	14235000
Year 5-2019	55000	35500	19500	795	15502500
Year 6-2020	55000	35500	19500	860	16770000
Year 7-2021	55000	35500	19500	925	18037500

Replace --Year-wise cash inflows
	Sale price	Operating costs	Net Income	Forecasted Demand	Total cash inflow
Year 1-2015	55000	26000	29000	535	15515000
Year 2-2016	55000	26000	29000	600	17400000
Year 3-2017	55000	26000	29000	665	19285000
Year 4-2018	55000	26000	29000	730	21170000
Year 5-2019	55000	26000	29000	795	23055000
Year 6-2020	55000	26000	29000	860	24940000
Year 7-2021	55000	26000	29000	925	26825000

	Year	Details	Modernize	Replace	PV Factor @ 10%	PV for Modernize	PV for Replace
2015 Beg.	0	Initial Investment	-36800000	-57400000	1	-36800000	-57400000
2015 End	1	Net cash inflows	10432500	15515000	0.9091	9484186	14104687
2016	2	Net cash inflows	11700000	17400000	0.8264	9668880	14379360
2017	3	Net cash inflows	12967500	19285000	0.7513	9742483	14488821
2018	4	Net cash inflows	14235000	21170000	0.683	9722505	14459110
2019	5	Net cash inflows	15502500	23055000	0.6209	9625502	14314850
2020	6	Net cash inflows	16770000	24940000	0.5645	9466665	14078630
2021	7	Net cash inflows	18037500	26825000	0.5132	9256845	13766590
2021	7	Disposal value	7000000	17000000	0.5132	3592400	8724400
		NPV of the decision				33759466	50916447
NOTE:Initial investment-Replace= 61700000-4300000

	Year	PV for Modernize	Cumulative PV	PV for Replace	Cumulative PV
2015 Beg.	0	-36800000	-36800000	-57400000	-57400000
2015 End	1	9484186	-27315814	14104686.5	-43295314
2016	2	9668880	-17646934	14379360	-28915954
2017	3	9742483	-7904452	14488820.5	-14427133
2018	4	9722505	1818054	14459110	31977
2019	5	9625502	11443556	14314849.5	14346827
2020	6	9466665	20910221	14078630	28425457
2021	7	9256845	30167066	13766590	42192047
2021	7	3592400	33759466	8724400	50916447

Pay-back period			3+(7904452/9722505)		3+(14427133/14459110
for the two alternatives			3.813005702		3.997788453
		ie.	3.81 yrs,		4 yrs.

4)

Factors should Clean Chips consider in choosing between the alternatives:

NPV is greater for REPLACE decision

Also, payback is only marginally greater than MODERNIZE for REPLACE decision

Hence, REPLACE decision is suggested

Generally, in choosing between alternatives, cash inflows and outflows to be generated, net present value of the  alternative, demand for the product, cost of machinery, its life, disposal value --are all taken into consideration

THANK YOU FOR THE QUESTION......KINDLY RATE....IT HELPS ME A LOT