Briar Corp is considering the purchase of a new piece of equipment. The cost sav

Question

Briar Corp is considering the purchase of a new piece of equipment. The cost savings from the equipment would result in an annual increase in cash flow of $200,000. The equipment will have an initial cost of $1,200,000 and have an 8 year life. The salvage value of the equipment is estimated to be $200,000. The hurdle rate is 8%. Ignore income taxes.

Answer the following:

a. What is the accounting rate of return?

b. What is the payback period?

c. What is the net present value?

d. What would the net present value be with a 12% hurdle rate?

e. Based on the NPV calculations, in what range would the equipment's internal rate of return fall?

Explanation / Answer

a.

Accounting rate of return = Average accounting Profit / Initial investment

Annual depreciation = (initial cost – Salvage value)/useful life = (1200000 – 200000)/8 = $125000

Annual accounting profit = annual cash inflow – annual depreciation = 200000 – 125000

Annual accounting profit = $75000

Accounting rate of return = 75000 / 1200000 = 6.25%

Accounting rate of return = 6.25%

b.

Payback period = Initial investment / annual cash inflow = 1200000/200000 = 6 years

C.

R = 8%

n = 8 years

Net present value = Present value of cash inflows + present value of salvage value – Present value of investments

Net present value = 200000*(1-1/(1+R)^n)/R + 200000/(1+R)^n - 1200000

Net present value = 200000*(1-1/(1+8%)^8)/8% + 200000/(1+8%)^8 - 1200000

Net present value = $57381.57

d.

With R = 12%

Net Present Value = 200000*(1-1/(1+12%)^8)/12% + 200000/(1+12%)^8 – 1200000

Net Present Value = -$125695.40

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