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Bleefl Corporation manufactures furniture in several divisions, including the patio furniture division. The manager of the patio furniture division plans to retire in two years. The manager receives a bonus based on the division's ROI, which is currently \(11 \%\). One of the machines that the patio furniture division uses to manufacture the furniture is rather old, and the manager must decide whether to replace it. The new machine would cost \(\$ 30,000\) and would last 10 years. It would have no salvage value. The old machine is fully depreciated and has no trade-in value. Bleefl uses straight-line depreciation for all assets. The new machine, being new and more efficient, would save the company \(\$ 5,000\) per year in cash operating costs. The only difference between cash flow and net income is depreciation. The internal rate of return of the project is approximately \(11 \% .\) Bleefl Corporation's weighted average cost of capital is \(6 \%\). Bleefl is not subject to any income taxes. 1\. Should Bleefl Corporation replace the machine? Why or why not? 2\. Assume that "investment" is defined as average net long-term assets after depreciation. Compute the project's ROI for each of its first five years. If the patio furniture manager is interested in maximizing his or her bonus, would the manager replace the machine before he or she retires? Why or why not? 3\. What can Bleefl do to entice the manager to replace the machine before retiring?

Step by step solution

01

Analyze Machine Replacement Decision

To decide whether to replace the machine, compare the internal rate of return (IRR) of 11% to the company's weighted average cost of capital (WACC) of 6%. Since the IRR exceeds the WACC, it's financially beneficial for the company to undertake the investment as it yields a return higher than the company’s cost of capital.

02

Compute Annual Depreciation and Annual Savings

Calculate the annual depreciation of the new machine: Cost is \\(30,000 over 10 years, so annual depreciation is \( \frac{30,000}{10} = \\)3,000 \). The new machine saves \$5,000 annually in cash operating costs.

03

Calculate Net Income Increase

Subtract the annual depreciation from the savings to find the annual increase in net income: \( 5,000 - 3,000 = \$2,000 \).

04

Determine Initial Average Investment

With straight-line depreciation, the average investment is calculated as: \( \frac{30,000 + 0}{2} = \$15,000 \). This value is used to compute ROI.

05

Compute ROI for First Five Years

ROI is calculated as \( \frac{\text{Net Income Increase}}{\text{Average Investment}} \times 100 \). Thus, ROI is \( \frac{2,000}{15,000} \times 100 = 13.33\% \). This computation holds constant for each of the first five years as both income and depreciation are stable.

06

Analyze Manager's Bonus Impact

The manager's current ROI is 11%. The new machine yields an ROI of 13.33%, therefore, replacing it would increase the manager's ROI and potentially their bonus. If maximizing the bonus before retirement is the goal, the replacement occurs.

07

Recommendation for Replacement Incentive

To encourage replacement before retirement, offer a special immediate bonus or recognition, acknowledging the future benefits from replacing the machine, independent of short-term ROI considerations.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Return on Investment (ROI)

Return on Investment (ROI) is an important metric in cost accounting that helps evaluate the efficiency of an investment. It is expressed as a percentage and provides insights into the profitability generated from an investment relative to its cost.

To calculate ROI, you can use the formula: \[ROI = \frac{\text{Net Profit}}{\text{Cost of Investment}} \times 100\] In the context of Bleefl Corporation, the ROI for the new machine is calculated based on the increase in net income and the average investment over the asset's life. Here, the net income increase is \\(2,000\ per year due to savings in cash operating costs and the cost of depreciation.

The average investment is \\)15,000\, computed as the average of the beginning and end-of-the-period book value of the asset. Using these figures, the ROI is calculated to be \(13.33\%\), which exceeds the current ROI of \(11\%\). Thus, replacing the machine is advantageous as it will lead to a higher return on investment compared to the previous situation. This positively impacts the manager's bonus, as their incentive is tied to ROI performance.

Depreciation

Depreciation is the accounting process used to allocate the cost of a tangible asset over its useful life. This concept reflects the wear and tear experienced by an asset as it generates revenue for the company.

Bleefl Corporation uses straight-line depreciation for its assets, where the cost of the asset is uniformly distributed over its useful life. For the new machine, costing \\(30,000\ over 10 years, the annual depreciation expense is: \[\text{Annual Depreciation} = \frac{30,000}{10} = \\)3,000\]The objective of depreciation is to match the cost of the asset with the revenue it generates.

In this scenario, straight-line depreciation simplifies calculations and impacts financial reporting by reducing taxable income gradually. The depreciation expense also impacts net income and therefore any ROI calculations, as it is deducted from gross savings to determine the resultant net income increase.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a crucial concept for evaluating potential investments, as it indicates the rate at which the net present value (NPV) of all cash flows from an investment equals zero. It reflects the profitability of potential investments.

For Bleefl Corporation, the IRR for the new machine is calculated at \(11\%\), which means the investment will generate a return of \(11\%\) annually over its ten-year life, covering the cost of capital and generating additional value.

The decision to replace the machine is supported by the fact that the IRR exceeds the company's Weighted Average Cost of Capital (WACC) of \(6\%\). This indicates that the project adds value to the company and aligns with long-term financial goals. The IRR thus acts as a benchmark for decision-making by comparing it with cost structures like WACC and enhances the company's profitability beyond surface financial metrics.