Mandel Manufacturing, Inc. has a manufacturing machine that needs attention. The

Question

Mandel Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of $2,200,000. If refurbished, Kilmer expects the machine to last another 8 years and then have no residual value. Option 2 is to replace the machine at a cost of $3,800,000. A new machine would last 10 years and have no residual value. Mandel expects the following net cash inflows from the two options:

$1,720,000

$430,000

Kilmer uses straight-line depreciation and requires an annual return of 14%.

Requirement 1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.

Compute the payback for both options. Begin by completing the payback schedule for Option 1 (refurbish).

Net Cash Outflows

Net Cash Inflows

Year

Amount Invested

Annual

Accumulated

0

$2,200,000

1

2

3

4

5

6

7

8

The payback for Option 1 (refurbish current machine) is _?___ years. (Round your answer to one decimal place.)

Now complete the payback schedule for Option 2 (purchase).

Net Cash Outflows

Net Cash Inflows

Year

Amount Invested

Annual

Accumulated

0

$3,800,000

1

2

3

4

5

6

7

8

9

10

The payback for Option 2 (purchase new machine) is __?__years. (Round your answer to one decimal place.)

Compute the ARR (accounting rate of return) for each of the options.

/

=

ARR

Refurbish

/

=

%

Purchase

/

=

%

Compute the NPV for each of the options. Begin with Option 1 (refurbish). (Enter the factors to three decimal places. X.XXX. Use parentheses or a minus sign for a negative net present value.)

Net Cash

PV Factor

Present

Years

Inflow

(i = 10%)

Value

Present value of each year's inflow:

1

(n = 1)

2

(n = 2)

3

(n = 3)

4

(n = 4)

5

(n = 5)

6

(n = 6)

7

(n = 7)

8

(n = 8)

Total PV of cash inflows

0

Initial investment

Net present value of the project

Now compute the NPV for Option 2 (purchase). (Enter the factors to three decimal places. X.XXX. Use parentheses or a minus sign for a negative net present value.)

Net Cash

PV Factor

Present

Years

Inflow

(i = 10%)

Value

Present value of each year's inflow:

1

(n = 1)

2

(n = 2)

3

(n = 3)

4

(n = 4)

5

(n = 5)

6

(n = 6)

7

(n = 7)

8

(n = 8)

9

(n = 9)

10

(n = 10)

Total PV of cash inflows

0

Initial investment

Net present value of the project

Finally, compute the profitability index for each option. (Round to two decimal places X.XX.)

/

=

Profitability index

Refurbish

/

=

Purchase

/

=

Requirement 2.

Which option should Kilmer choose? Why? Review your answers in Requirement 1.

Kilmer should choose__?_________because this option has a ___?_______ payback period, and ARR that is __?______ the other option, a ___?______ NPV, and its profitability index is ____?_____.

Years Refurbish Current Machine Purchase New Machine 1

$1,720,000

$2,520,000 2

$430,000

$610,000 3 $320,000 $500,000 4 $210,000 $390,000 5 $100,000 $280,000 6 $100,000 $280,000 7 $100,000 $280,000 8 $100,000 $280,000 9 $280,000 10 $280,000 Total $3,080,000 $5,700,000

Explanation / Answer

Kimiler should Choose Refurbishbecause the option has a 2.2 years payback period and
ARR that is 17.5% the other option A & 319, 368 NPV and PI is 1.15

1 Refurnish Net Cash Outflow Net Cash Inflow Amount Invested Annual Accumulated Year 0               2,200,000    -2,200,000 Year 1          1,720,000       -480,000 Year 2             430,000         -50,000 Year 3             320,000        270,000 Year 4             210,000        480,000 Year 5             100,000        580,000 Year 6             100,000        680,000 Year 7             100,000        780,000 Year 8             100,000        880,000 2+50000/320000 =                2.2 years Purchase Net Cash Outflow Net Cash Inflow Amount Invested Annual Accumulated Year 0               3,800,000    -3,800,000 Year 1          2,520,000    -1,280,000 Year 2             610,000       -670,000 Year 3             500,000       -170,000 Year 4             390,000        220,000 Year 5             280,000        500,000 Year 6             280,000        780,000 Year 7             280,000     1,060,000 Year 8             280,000     1,340,000 Year 9             280,000     1,620,000 Year 10             280,000     1,900,000 Pay Back Period 3+170000/390000 3.4 years formula for payback period = X+Y/Z X is the last period with negetive cummulative cash flow Y is the absolute value of cummulative cash flow at end of period X Z is the total cash flow during the perioed after A Accounting Rate of return Average return/average investment Average return Profit after tax/Life of investment Averager return Investment ARR Refubrish 385000          2,200,000 17.5% Purchase 570000          3,800,000 15.0% NPV Refurnish Net Cash Outflow Net Cash Inflow Amount Invested Annual NPV Year 0              -2,200,000    -2,200,000 Year 1          1,720,000     1,563,636 Year 2             430,000        355,372 Year 3             320,000        240,421 Year 4             210,000        143,433 Year 5             100,000          62,092 Year 6             100,000          56,447 Year 7             100,000          51,316 Year 8             100,000          46,651 NPV        319,368 Purchase Net Cash Outflow Net Cash Inflow Amount Invested Annual NPV Year 0              -3,800,000    -3,800,000 Year 1          2,520,000     2,290,909 Year 2             610,000        504,132 Year 3             500,000        375,657 Year 4             390,000        266,375 Year 5             280,000        173,858 Year 6             280,000        158,053 Year 7             280,000        143,684 Year 8             280,000        130,622 Year 9             280,000        118,747 Year 10             280,000        107,952 NPV        469,990 Profitability Index PV of future cash flow/Initial Investment PV of cash flow Investment PI Refubrish               2,519,368          2,200,000              1.15 Purchase               4,269,990          3,800,000              1.12 2

Kimiler should Choose Refurbishbecause the option has a 2.2 years payback period and
ARR that is 17.5% the other option A & 319, 368 NPV and PI is 1.15

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