Basics of Capital Investment

Kenn Day, manager of Day Laboratory, is investigating the possibility of acquiring some new test equipment. To acquire the equipment requires an initial outlay of $300,000. To raise the capital, Kenn will sell stock valued at $200,000 (the stock pays dividends of $24,000 per year) and borrow $100,000. The loan for $100,000 would carry an interest rate of 6 percent. Kenn figures that his weighted average cost of capital is 10 percent [(2/3 X 0.12) + (1/3 X 0.06)].

This weighted cost of capital is the discount rate that will be used for capital investment decisions.

Kenn estimates that the new test equipment will produce a cash inflow of $50,000 per year. Kenn expects the equipment to last for 20 years.

Required

1. Compute the payback period.

2. Assuming that depreciation is $14,000 per year, compute the accounting rate of return (on total investment).

3. Compute the NPV of the test equipment.

4. Compute the IRR of the test equipment.

5. Should Kenn buy the equipment?