Question

Bethlehem Company plans to replace an old piece of equipment that has no book value for tax purposes and no salvage value. The replacement equipment will provide annual cash savings of $8,000 before income taxes. The equipment costs $20,000 and will have no salvage value at the end of its five-year life. Bethlehem uses straight line depreciation method for both book and tax purposes. The company incurs a 40% marginal tax rate, and its after-tax cost of capital is 14%.

Required:

Compute the following performance measures for Bethlehem’s proposed investment:

1. Payback period
2. Payback reciprocal
3. Accrual accounting rate of return on average investment.

Answer 1

Pretax annual cash savings	$         8,000
Less: Depreciation (20000/5)	$         4,000
Net Operating Income	$         4,000
Less: Tax at 40%	$         1,600
NOPAT	$         2,400
ADD: Depreciation	$         4,000
OCF	$         6,400
Payback period (20000/6400)	3.13 Years
Payback reciprocal (1/3.125)	32.00%
AARR = [2400/(20000/2)]	24.00%