A piece of laborsaving equipment has just come onto the market that Mitsui Elect
ID: 2499322 • Letter: A
Question
A piece of laborsaving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow:
If the company requires a payback period of four years or less, would the equipment be purchased?
Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment’s useful life.
A piece of laborsaving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow:
Explanation / Answer
(1-a)
Payback period (PBP) is the time by which a project recovers its initial investment, that is, time when cumulative cash flows become zero.
As seen above, PBP falls between years 5 & 6.
PBP = 5 + (Absolute cumulative cash flow in year 5 / Cash flow in year 6)
= 5 + $(9,000 / 90,000) = 5 + 0.1 = 5.1 years
Note: To compute PBP, entire project life is not needed for consideration.
(1-b)
If desired PBP is 4 years, project should not be accepted since it has higher PBP.
(2-a)
Annual depreciation = $459,000 / 12 = $38,250
Net annual cost saving (Net annual benefit, NAB) = $(90,000 - 38,250) = $51,750
Total benefit in 12 years = $51,750 x 12 = $621,000
Simple annual rate of return = $(621,000 / 459,000)1/12 - 1 = (1.3529)1/12 - 1 = 1.0255 - 1 = 0.0255, or 2.55%
[Note: Simple overall rate of return = (621,000 / 459,000) - 1 = 1.3529 - 1 = 35.29%]
(d) Required rate of return (ROR) = 13%
If we go by annual ROR which is 2.55%, project should not be accepted because actual ROR < required ROR.
If we go by overall ROR which is 35.29%, project should be accepted because actual ROR > required ROR.
Year Cash Flow ($) Cumulative Cash Flow ($) 0 -4,59,000 -4,59,000 1 90000 -3,69,000 2 90000 -2,79,000 3 90000 -1,89,000 4 90000 -99,000 5 90000 -9,000 6 90000 81,000Related Questions
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