equipment replacement no income taxes pro chips is a 268883

Equipment replacement, no income taxes. Pro Chips is a manufacturer of prototype chips based in Dublin, Ireland. Next year, in 2010, Pro Chips expects to deliver 552 prototype chips at an average price of $80,000. Pro Chips’ marketing vice president forecasts growth of 60 prototype chips per year through 2016. That is, demand will be 552 in 2010, 612 in 2011, 672 in 2012, and so on. The plant cannot produce more than 540 prototype chips annually. To meet future demand, Pro Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $3,600,000 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:

Pro 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 2010, and all transactions thereafter occur on the last day of the year. Pro Chips’ required rate of return is 12%. There is no difference between the modernize and replace alternatives in terms of required working capital. Pro Chips has a special waiver on income taxes until 2016.

1. Sketch the cash inflows and outflows of the modernize and replace alternatives over the 2010 to 2016 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 Pro Chips consider in choosing between thealternatives?