P11-31 Ethics problem (LG 2; Intermediate)
The person who came up with the idea for a new investment may have a selfish interest in seeing
the project approved or may simply be emotionally vested in the project. In either case, this individual
Case: “Developing Relevant Cash Flows for Clark Upholstery
Company’s Machine Renewal or Replacement Decision”
Case studies are available on www.pearson.com/mylab/finance.
Clark Upholstery must decide whether to renew a major piece of machinery or replace the machine. The
case tests the students’ understanding of the concepts of initial investment and relevant cash flows.
a. Initial Investment: Alternative 1 Alternative 2
Installed cost of new asset
Cost of asset $90,000 $100,000
Installation costs 0 10,000
Total proceeds, sale of new asset 90,000 110,000
After-tax proceeds from sale of old asset
$20,000
(0.40)
$8,000 tax
b.
Calculation of Operating Cash Inflows
Year
Profits
before
Depreciation
and Taxes Depreciatio
n
Net Profits
before
Taxes Taxes Net Profits
after Taxes
Operating
Cash
Inflows
Alternative 1
1 $198,50
0$18,000 $180,500 $72,2
00 $108,30
0$126,30
0
2 290,800 28,800 262,000 104,8
00 157,200 186,000
0
Alternative 2
1 $235,50
0$22,000 $213,500 $85,4
00 $128,10
0$150,10
0
2 335,200 35,200 300,000 120,0
00 180,000 215,200
Calculation of Incremental Cash Inflows
Incremental Cash Flow
Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2
1 $126,300 $150,100 $100,000 $26,300 $50,100
2 186,000 215,200 150,000 36,000 65,200
3 235,980 239,420 200,000 35,980 39,420
c. Terminal Cash Flow:
Alternative 1 Alternative 2
After-tax proceeds from
sale of new asset
Proceeds from sale of new asset $8,000 $25,000
Change in working capital 15,000 22,000
Terminal cash flow $20,400 $38,000
*Book value of Alternative 1 at end of year 5
$4,500, so recaptured depreciation is $8,000
$4,500
$3,500,
Alternative 1
Year 5 relevant cash flow:
Operating cash flow:
Alternative 2
Year 5 relevant cash flow:
Operating cash flow:
d. Alternative 1
A l t e r n a t i v e 1
A l t e r n a t i v e 2
6
E N D O F Y E A R
C a s h F l o w s
C a s h F l o w s
E N D O F Y E A R
0
1
2
3
4
5
– 1 0 5 , 0 0 0
0
– 1 2 0 , 0 0 0
$ 5 0 , 1 0 0
6 5 , 2 0 0
3 9 , 4 2 0
1 6 , 3 4 0
5 3 , 9 4 0
3
2
6
5
4
4 3 , 4 6 0
3 5 , 9 8 0
3 6 , 0 0 0
5 3 , 8 6 0
$ 2 6 , 3 0 0
1
e. Alternative 2 appears to be slightly better because it offers larger incremental cash flows in the early
Alternative 1 (22.04%).
Spreadsheet Exercise
Answers to Chapter 11’s Damon Corporation exercise are available on www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.pearson.com/mylab/finance .
Capital investment is revisited in this chapter’s group exercise. A long-term investment project will be
detailed across this and the following two chapters. Students are warned that while this chapter’s exercise is
apparently brief, the work is vital to the work in the following chapters.
The first task is to design two mutually exclusive investment projects. The design should focus on why
these investments should each be undertaken. After establishing the “why” for each project, the process
A payback period, net present value, and internal rate of return are estimated for both projects. If the
projects have different sizes, it may be possible for the smaller project to have a higher internal rate of