I. Payback period computation; even cash flows Compute the payback period for each of the following two separate investments (round the payback period to two decimals):
1. A new operating system for an existing machine is expected to cost $260,000 and have a useful life of five years. The system yields an incremental after-tax income of $75,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000.
Payback period=Cost of investment/ Annual net cash flow =$260,000/ $125,000 =2. 08 years
Annual depreciation= $260,000 -$10,000 / 5 = $50,000
Annual after tax income $75,000
Annual net cash flow$125,000
2. A machine costs $190,000, has a $10,000 salvage value, is expected to last nine years, and will generate an after-tax income of $30,000 per year after straight-line depreciation.
Payback period=Cost of investment/ Annual net cash flow =$190,000/ $50,000 =3. 8 years
Annual depreciation= $190,000 -$10,000 / 9 = $20,000
Annual after tax income $30,000 + Depreciation 20,000 Annual net cash flow$50,000
II. Payback period computation; uneven cash flows Wenro Company is considering the purchase of an asset for $90,000. It is expected to produce the following net cash flows.
The cash flows occur evenly throughout each year. Compute the payback period for this investment. Part of year= Amount paid back in year 4/ Net cash flows in year 4 = $10,000 / $60,000 = 0. 167 Payback period=3 + 0. 167 = 3. 1367 years = 3yrs 2 mos.
III. Accounting Rate of Return
A machine costs $500,000 and is expected to yield an after-tax net income of $15,000 each year. Management predicts this machine has a 10-year service life and a $100,000 salvage value, and it uses straight-line depreciation. Compute this machine’s accounting rate of return.
Average investment=$500,000 + $100,000 / 2 $300,000
Accounting rate of return=$15,000 / $300,000 = 5%
IV. Computing Net Present Value K2B
The company is considering the purchase of equipment that would allow the company to add a new product to its line. The equipment is expected to cost $240,000 with a 12-year life and no salvage value. It will be depreciated on a straight-line basis. The company expects to sell 96,000 units of the equipment’s product each year. The expected annual income related to this equipment follows. K2B concludes that the investment must earn at least an 8% return. Compute the net present value of this investment. Round the net present value to the nearest dollar. )
Net cash flows from net income
1. Payback period=$240,000 / $44,500 = 5. 39 years
2. Accounting rate of return=$24,500 / $120,000 = 20. 42%
V. Net Present Value Interstate
Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.
Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value.
1. Determine the net present value of alternative 1. Keep the old machine and have it overhauled
Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more products being produced and sold.
2. Determine the net present value of alternative 2. Sell the old machine and buy a new one
3. Which alternative do you recommend that management select?
Explain. Interstate should keep the old machine and overhaul it. The cost savings and additional revenue generated on the new machine are not enough to overcome the high initial cost of the new machine.