Question

Exercise 12-6 (Video) BSU Inc. wants to purchase a new machine for $44,300, excluding $1,500 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 $10,000 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 PV table. (a) Determine the cash payback period. (Round cash payback period to 2 decimal places, e.g. 10.53.) Cash payback period 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 % (c) Assuming the company has a required rate of return of 8%, determine whether the new machine should be purchased. The investment be accepted. Click if you would like to Show Work for this question: Open Show Work

Answer 1

Solution a:

Initial investment = Cost of new machine - Sale value of old machine = ($44,300 + $1,500) - $2,200 = $43,600

Annual cash inflows from new machine = Saving in operating cost = $10,000

Cash payback period = Initial investment / Annual cash inflows = $43,600 / $10,000 = 4.36 years

Solution b:

Present value of annuity of $1 at IRR for 6 periods = $43,600 / $10,000 = 4.36

Refer PVA of $1, the factor lies on IRR = 10%

Hence IRR = 10%

Solution c:

As IRR is higher than required rate of return, therefore new machine should be purchased.