Question

BioFarm Inc. wants to replace its current equipment with new high-tech equipment. The existing equipment was purchased 5 years ago at a cost of $122,000. At that time, the equipment had an expected life of 10 years, with no expected salvage value. The equipment is being depreciated on a straight-line basis. Currently, the market value of the old equipment is $43,300. The new equipment can be bought for $174,900, including installation. Over its 10-year life, it will reduce operating expenses from $192,600 to $145,100 for the first six years, and from $204,500 to $191,300 for the last four years. Net working capital requirements will also increase by $20,400 at the time of replacement. It is estimated that the company can sell the new equipment for $24,600 at the end of its life. Since the new equipment’s cash flows are relatively certain, the project’s cost of capital is set at 10%, compared with 15% for an average-risk project. The firm’s maximum acceptable payback period is 5 years. Click here to view PV table.

(a)

	Your answer is correct.

Calculate the initial investment amount.

Initial investment

$

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Attempts: 1 of 3 used

(b)

Calculate the project’s cash payback period. (Round answer to 2 decimal places, e.g. 15.25.)

Cash payback period

years

Answer 1

(a) Initial investment = Purchase + installation cost of new equipment + Working capital requirements - Market value of old equipment

Initial investment = $174900 + $20400 - $43300 = $152000

Initial investment: $152000

(b)

Year	Cash Flow	Cumulative Cash Flow
0	-152000	-152000
1	47500	-104500
2	47500	-57000
3	47500	-9500
4	47500	38000
5	47500
6	47500
7	13200
8	13200
9	13200
10	13200

Cash flow for years 1 - 6 = Savings in operating expenses = $192600 - $145100 = $47500

Cash flow for years 7 - 10 = Savings in operating expenses = $204500 - $191300 = $13200

Since the cumulative cash flow becomes positive from negative in year 4, the payback period lies between years 3 and 4.

Cash payback period = 3 + [38000/(9500 + 38000)] = 3 + [38000/47500] = 3 + 0.80 = 3.80 years

Cash payback period: 3.80 years