21-29

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.

1. Sketch the cash inflows and outflows of the modernize and replace alternatives over the 20152021 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?