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Base-case analysis: Should the replacement asset be purchased? That is, does it make economic (financial) sense of XYZ to replace the existing
Base-case analysis: Should the replacement asset be purchased? That is, does it make economic (financial) sense of XYZ to replace the existing machine? Support your answer by clearly showing the tax basis of the replacement asset (if purchased and under the assumption that the existing asset would be sold outright rather than traded in) and the annual after-tax cash flows associated with both decision options. Remember to record appropriate depreciation expense under MACRS for the existing asset is assumed to occur on January 1, 2015, while the tax savings due to depreciation deductions under MACRS, as well as tax-related effects of the disposal (if any), are assumed to be realized at the end of 2015. Base your recommendation on both an NPV analysis and a comparison of the IRR associated with each of the two investment alternatives (keep vs. replace). Comment on your comparative results. Round all calculations, including intermediate calculations, to whole numbers (i.e., to zero decimal points). Dealing with Uncertainty/Sensitivity Analysis: Issues related to the discount rate: How (conceptually) is the discount rate for capital budgeting purposes defined and calculated? Is this number appropriate for analysing the asset-replacement decision at hand? Why or why not? What impact, if any, would a rate below or above 10% have on the recommended course of action for XYZ Company? To address this issue, first prepare a schedule in Excel showing what the NPV results of the base-case analysis would be after letting the WACC vary from a low of 8% to a high of 13%, in increments of 1%. For each discount rate, recalculate the difference in NPV of the two investment alternatives. Next, use the Data Table option in Excel to perform and present the results of this sensitivity analysis. Finally, using the Goal Seek option in Excel, determine the "breakeven" discount rate, that is, the rate that would make XYZ indifferent between the two decision options (based on an NPV analysis of the base-case facts). Estimates of annual pre-tax cash inflows of the replacement machine: Use the Goal Seek option in excel to determine the breakeven operating pre-tax cash inflow associated with the replacement asset (i.e, the annual pre-tax cash inflow for the replacement machine that would make XYZ indifferent between keeping vs. replacing the existing machine). What keen managerial insight is yielded from this analysis? Addressing incremental investment in (net) working capital: respond to the two queries raised by Watson regarding the possible need to make an up-front commitment of additional (net) working capital if the replacement machine purchased: I. Does the base-case analysis need to be changed? Why or why not? II. If the team replaces the machine, XYZ would have to commit to incremental (net) working capital of $20,000. Would this incremental investment affect the recommended course of action? (Show calculations) Unequal asset lives: Under the assumption that the useful lives of the two assets differ, a possibility noted by smith, and based on the use of the NVP decision model, provide a recommendation as to which asset XYZ should choose. Support your answer with appropriate calculations and citations to the literature. Additional Tax-Related Issues: Like-kind exchanges, IRC §1031: Prepare a response with supporting calculations (if appropriate) to the two tax-related questions raised by Smith in conjunction with the possibility of trading in rather than selling the existing machine outright (if the new machine were purchased): I. Would there be any tax advantage to trading in (rather than selling) the old asset? II. What would the breakeven value of the trade in be? Note: When responding to Smith's second question, assume base-case data. For purposes of responding to this question, you can ignore the incremental investment in net working capital (if any) that would be required in the new asset is purchased. Applicability of IRC §179: Prepare a response, with appropriate authoritative support, to the two questions raised by Smith regarding the provisions of IRC §179, as it pertains to expensing of the cost of the replacement asset: Does XYZ have this option? What are the benefits of this option (if any)? Use of a STARKER escrow in conjunction with the disposal of the existing asset: Prepare a response, with authoritative support, to Chang's issue regarding the STARKER escrow: What is it and is it applicable to the present situation? Strategic and/or Qualitative Considerations/Multi-Criteria Decision Models: Incentive effects: Calculate the book loss (i.e., the loss for financial reporting purposes) that Callaway references regarding the disposal (i.e., the outright sale) of the old machine. What effect should the book value have on the decision to purchase the new machine? How will external users, such as shareholders, likely react to this information? What incentive does Watson have in representing the length of time for retooling? How might the present decision affect customer relations? What general issue regarding incentive effects and the design of management accounting control systems in raised by this example? Demand and pricing-related considerations: Expand on Callaway's criticisms from a strategic perspective. For example, what does he mean by "squeezing margins"? What economic assumption regarding price elasticity of demand is XYZ making for its products? How does XYZ balance its desire to gain market share through cost efficiencies with the "commitment" it made to shareholders regarding the original machine? Additional qualitative/ strategic considerations and the use of multi-criteria decision models: Prepare a response to the two questions raised by Smith regarding strategic/qualitative considerations associated with the proposed investment: I. What additional non-financial/strategic factors (beyond those discussed in 4 (a) and 4(b)) might bear on the decision facing XYZ Company? II. How could such factor (if any) be formally incorporated into a capital budgeting analysis? To the extent possible, support your position by offering several additional qualitative/strategic considerations and by referencing the appropriate literature (e.g., the literature pertaining to multi-criteria decision making" models as applied to a capital budgeting context). Project Evaluation Summary: Prepare a summary report (in the form of a table) that reflects the major issues addressed in the case. Each row in your table should deal with a separate issue you addressed. For each issue, provide a statement as to whether and why (or how) the issue at hand would affect the recommended decision as well as any additional information you think is pertinent. Assume that the document you prepare would be the type that could be used to guide the discussion at the decision team's final meeting (or the presentation of your report to a client) and that the project evaluation summary would be supported by the various analyses conducted in conjunction with answering previous case questions.
