Review Questions
I. Payback period and 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.
2. A machine costs $190,000, has a $10,000 salvage value, is expected to last nine years
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.
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Total |
| Net cash flows |
$30,000 |
$20,000 |
$30,000 |
$60,000 |
$19,000 |
$159,000 |
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.
IV. Computing Net Present Value
K2B 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:
|
Sales .............................................................................
|
$150,000
|
|
Costs
|
|
|
Materials, labor, and overhead (except depreciation) ........
|
80.000
|
|
Depreciation on new equipment .....................................
|
20.000
|
|
Selling and administrative expenses ...............................
|
15,000
|
|
Total costs and expenses..................................................
|
115,000
|
|
Pretax income ................................................................
|
35.000
|
|
Income taxes (30%) .......................................................
|
10,500
|
|
Net income ....................................................................
|
$ 24,500
|
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.)
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.
|
Cost of old machine ...................................
|
$112,000
|
|
Cost of overhaul.........................................
|
150,000
|
|
Annual expected revenues generated ........................
|
95,000
|
|
Annual cash operating costs after overhaul.................
|
42,000
|
|
Salvage value of old machine in 5 years ....................
|
15,000
|
Alternative 2: Sell the old machine and buy a new one. The new machine will be more efficient and will yield substantial operating cost savings with more products produced and sold.
Cost of new machine ................................................. $300.000
Salvage value of old machine now .......................... 29,000
Annual expected revenues generated .................. 100,000
Annual cash operating costs .................................... 32,000
Salvage value of new machine in 5 years ................ 20,000
1. Determine the net present value of alternative 1.
2. Determine the net present value of alternative 2.
3. Which alternative do you recommend management select? Explain.