HARTSELL MANUFACTURING puts much emphasis on cash flow when it plans for capital

Question

HARTSELL MANUFACTURING puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 8% based on the rate of return it must pay its owners and creditors. Using that rate, HARTSELL MANUFACTURING then uses different methods to determine the best decisions for making capital outlays.

In 2014 HARTSELL MANUFACTURING is considering buying five new backhoes to replace the backhoes it now has. The new backhoes are faster, cost less to run, provide for more accurate trench digging, have comfort features for the operators, and have 1-year maintenance agreements to go with them. The old backhoes are working just fine, but they do require considerable maintenance. The backhoe operators are very familiar with the old backhoes and would need to learn some new skills to use the new backhoes.

The following information is available to use in deciding whether to purchase the new backhoes.

Old Backhoes New Backhoes

Purchase cost when new $90,000 $200,000

Salvage value now $42,000

Investment in major overhaul needed in next year $55,000

Salvage value in 8 years $15,000 $90,000

Remaining life 8 years 8 years

Net cash flow generated each year $30,425 $43,900

(a) Evaluate in the following ways whether to purchase the new equipment or overhaul the old equipment. (Hint: For the old machine, the initial investment is the cost of the overhaul. For the new machine, subtract the salvage value of the old machine to determine the initial cost of the investment.)

(1) Using the net present value method for buying new or keeping the old.

(2) Using the payback method for each choice. (Hint: For the old machine, evaluate the payback of an overhaul.)

(3) Comparing the profitability index for each choice.

(4) Comparing the internal rate of return for each choice to the required 8% discount rate.

(b) Are there any intangible benefits or negatives that would influence this decision?

(c) What decision would you make and why?

Explanation / Answer

Old Backhoes New Backhoes Old Backhoes New backhoes Purchase Price 200000 Investment required in Yr 1 55000 Salvage value Now 42000 Salavage value after 8 years 15000 90000 Cash Inflow 30425 43900 New mavhine Year Cash Flow Discount factor 8*% Discounted cash Flow Discount factor 25*% Discounted cash Flow Discount factor 25.67*% Discounted cash Flow 0 -158000 1 -158000 1 -158000 1 -158000 1 43900 0.9259 40648.15 0.8 35120 0.8 34932.76 2 43900 0.8573 37637.17 0.64 28096 0.6332 27797.22 3 43900 0.7938 34849.24 0.512 22476.8 0.5039 22119.21 4 43900 0.7350 32267.81 0.4096 17981.44 0.4009 17601.03 5 43900 0.6806 29877.6 0.3277 14385.15 0.3190 14005.75 6 43900 0.6302 27664.45 0.2621 11508.12 0.2539 11144.87 7 43900 0.5835 25615.23 0.2097 9206.497 0.2020 8868.358 8 43900 0.5403 23717.8 0.1678 7365.198 0.1607 7056.862 8 90000 0.5403 48624.2 0.1678 15099.49 0.1607 14467.37 NPV 142901.6 3238.703 -6.57465 IRR is where NPV=0 , so we will do trial and error lets take 25% IRR 25.67% Profitability Index=1+NPV/Intial Investment required 1+142902/158000 1.90 Payback period= 158000/43900 3.60 Old machine Year Cash Flow Discount factor 8*% Discounted cash Flow Discount factor 54*% Discounted cash Flow Discount factor 90*% Discounted cash Flow 1 -55000 0.9259 -50925.9 0.649351 -35714.3 0.5 -28947.4 1 30425 0.9259 28171.3 0.64935 19756.49 0.5 16013.16 2 30425 0.8573 26084.53 0.4217 12828.89 0.2770 8427.978 3 30425 0.7938 24152.35 0.2738 8330.449 0.1458 4435.778 4 30425 0.7350 22363.28 0.1778 5409.383 0.0767 2334.62 5 30425 0.6806 20706.74 0.1155 3512.586 0.0404 1228.747 6 30425 0.6302 19172.91 0.0750 2280.9 0.0213 646.7091 7 30425 0.5835 17752.7 0.0487 1481.104 0.0112 340.3732 8 30425 0.5403 16437.68 0.0316 961.7558 0.0059 179.1438 8 15000 0.5403 8104.033 0.0316 474.1606 0.0059 88.32069 NPV 132019.6 19321.44 4747.459 IRR is where NPV=0 , so we will do trial and error lets take 90%, its above 90% Profitability Index=1+NPV/Intial Investment required 1+(132020/30425) 5.34 Payback period= 55000/30425 1.81 Ans 2 as bakhoe operator are familiar and comfortable with old backhoe so this is the intangible benefit for old backhoe With new backhoe the operators will not be comfortable as was old backhoe, so it’s a disadvantage for new backhoe May be training would berequired this can also add cost as the hours of the workers will be spent on it. Ans 3 Old backhoe shuld be continued as IRR, profitability index and payback period is more and NPV is slightly down

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