BSU Inc. wants to purchase a new machine for $28,100, excluding $1,400 of instal

Question

BSU Inc. wants to purchase a new machine for $28,100, excluding $1,400 of installation costs. The old machine was bought five years ago and had an expected economic life of 10 years without salvage value. This old machine now has a book value of $2,000, and BSU Inc. expects to sell it for that amount. The new machine would decrease operating costs by $6,500 each year of its economic life. The straight-line depreciation method would be used for the new machine, for a six-year period with no salvage value.

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(a)

Determine the cash payback period. (Round cash payback period to 1 decimal place, e.g. 10.5.)

(b)

Determine the approximate internal rate of return. (Round answer to 0 decimal places, e.g. 10. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

(c)

Assuming the company has a required rate of return of 9%, determine whether the new machine should be purchased.

Explanation / Answer

a)

Initial Investment = New Machine Cost + Installation cost - Sale Value of old machine

Initial Investment = 28100+1400 - 2000

Initial Investment = 27500

Annual cash Flow = 6500

Cash payback period = Initial Investment / Annual cash Flow

Cash payback period = 27500/6500

Cash payback period = 4.2 years

b)

At IRR

PV of Cash Inlfow = PV of cash outflow

6500*PVIFA(rate,6) = 27500

PVIFA(rate,6) = 27500/6500

PVIFA(rate,6) = 4.23077

Using PV factor table

We get

rate = 11%

Answer

Internal rate of return = 11%

c)

Yes the new machine should be purchased , since its IRR is greater than required rate of return

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