Question

Quip Corporation wants to purchase a new machine for $300,000. Management predicts that the machine will produce sales of $182,000 each year for the next 5 years. Expenses are expected to include direct materials, direct labor, and factory overhead (excluding depreciation) totaling $78,000 per year. The firm uses straight-line depreciation with an assumed residual (salvage) value of $50,000. Quip's combined income tax rate, t, is 20%.

Management requires a minimum of 10% return on all investments. What is the approximate present value payback period, rounded to one-tenth of a year? (Note: PV $1 factors for 10% are as follows: year 1 = 0.909; year 2 = 0.826; year 3 = 0.751; year 4 = 0.683; year 5 = 0.621; the PV annuity factor for 10%, 5 years = 3.791.) Assume that annual after-tax cash inflows occur evenly throughout the year.

Multiple Choice

1.5 years.

3.8 years.

2.6 years.

2.0 years.

3.1 years.

Answer 1

Annual Cash Inflow

Operating Cash Flow = [(Additional annual revenues - Annual Cash Operating Expenses (1 – Tax Rate) + [(Depreciation x Tax Rate)]

= [($182,000 – 78,000) x (1 – 0.20)] + [$50,000 x 0.20]

= $83,200 + 10,000

= $93,200

Depreciation Expense

Depreciation Expense = [Cost of the Assets – Salvage Value] / Useful life

= [$300,000 – 50,000] / 5 Years

= $50,000

Payback Period

Payback Period of the Project = Initial Investment / Annual cash flow

= $300,000 / 93,200

= 3.1 Years

“Payback Period = 3.1 years”