Equipment replacement, no income taxes. Clean Chips is a manufacturer of prototy

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.. 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?

Explanation / Answer

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

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

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