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 ten years. It would have no salvage value. The old machine is fully amortized and has no trade-in value. Bleefl uses straight-line amortization 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 amortization. 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 amortization.
Compute the project’s ROI for each time period t1 to t5 when each time period is 1 year.
If the Patio Furniture manager is interested in maximizing his bonus, would he replace the machine before he retires? Why or why not?
3. What can Bleefl do to entice the manager to replace the machine before retiring?