Question

23-26:

Comfy Corporation manufactures furniture in several divisions, including
the patio furniture division. The manager of the patio furniture division plans to retire in two years.
The manager receives a bonus based on the division’s ROI, which is currently 7%.
One of the machines that the patio furniture division uses to manufacture the furniture is rather old,
and the manager must decide whether to replace it. The new machine would cost $35,000 and would last
10 years. It would have no salvage value. The old machine is fully depreciated and has no trade-in value.
Comfy uses straight-line depreciation for all assets. The new machine, being new and more efficient, would
save the company $5,000 per year in cash operating costs. The only difference between cash flow and net
income is depreciation. The internal rate of return of the project is approximately 7%. Comfy Corporation’s
weighted-average cost of capital is 5%. Comfy is not subject to any income taxes.

1. Should Comfy Corporation replace the machine? Why or why not?
2. Assume that “investment” is defined as average net long-term assets (that is, after depreciation) during
the year. Compute the project’s ROI for each of its first five years. If the patio furniture manager is
interested in maximizing his bonus, would he replace the machine before he retires? Why or why not?

3. What can Comfy do to entice the manager to replace the machine before retiring?

*PLEASE SHOW ALL CALCULATIONS*

Answer 1