Case: "Replacement Project Analysis" by by Jim De Mello

Using the attached case study and tables, please solve the below problems:

Questions:

1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.

3. As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so as to arrive at a good and well justified decision?

4. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project.

5. How are the interim cash flows to be computed for the productive life of the new machinery? How is depreciation to be accounted for?

6. As a shrewd financial analyst you observe that the net working capital of the firm has typically been about 20% of the annual revenues. How would you incorporate this observation into the analysis?

7. How should the annual interest expenses on the bank loan be handled? Explain.

8. What is the relevance of the terminal year cash flow? Which factors must be considered when estimating the terminal year cash flow?

9. After looking at the data provided by Vic, you realize that the revenue and cost figures have not been adjusted for inflation. If inflation was expected to be at least 3% per year, what effect would this have on your analysis? Adjust the data and recalculate the relevant cash flows.

10. What recommendation would you make to Vic regarding the replacement of the old coating machine? Explain.

11. If the new machine has an economic life of 15 years while the current machine has a life of only 10 years, how would the capital budgeting analysis have to be adjusted? Please explain by performing the necessary calculations.