Question

BSU Inc. wants to purchase a new machine for $35,525, excluding $1,400 of installation costs. The old machine was bought five years ago and had an expected economic life of 10 years without salvage value. This old machine now has a book value of $2,200, and BSU Inc. expects to sell it for that amount. The new machine would decrease operating costs by $7,500 each year of its economic life. The straight-line depreciation method would be used for the new machine, for a six-year period with no salvage value. Click here to view the factor table. (a) Determine the cash payback period. (Round cash payback period to 2 decimal places, e.g. 10.53.) Cash payback period enter the Cash payback period in years rounded to 2 decimal places years (b) Determine the approximate internal rate of return. (Round answer to 0 decimal places, e.g. 13%. For calculation purposes, use 5 decimal places as displayed in the factor table provided.) Internal rate of return enter the Internal rate of return in percentages rounded to 0 decimal places % (c) Assuming the company has a required rate of return of 6%, determine whether the new machine should be purchased. The investment select an option be accepted.

Answer 1

Solution a:

Initial investment = Cost of new machine + Installation cost - Sale value of old machine = $35,525 + $1,400 - $2,200 = $34,725

Annual cash inflows = Annual decrease in operating cost = $7,500

Cash payback period = Initial investment / Annual cash inflows = $34,725 / 7500 = 4.63 years

Solution b:

Present value factor at IRR = Initial investment / Annual cash inflows = $34,725 / 7500 = 4.63years

Refer PV Factor table at 6 periods, this factor falls near to IRR = 8%

Hence IRR = 8%

Solution c:

As IRR is higher than required rate of return, therefore the investment should be accepted.

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