A salad oil bottling plant can either buy caps for the glass bottles at $0.05 ea

Question

A salad oil bottling plant can either buy caps for the glass bottles at $0.05 each or install $500,000 worth of plastic molding equipment and manafacture the caps at the plant. The manufacturing engineer estimates the material, labor, and other costs would be $0.03 per cap.

a) If 12 million caps per year are needed and the molding equipment is installed, what is the payback period?

b) The plastic molding equipment would be depreciated by straight-line depreciation using a 5-year useful life and no salvage value. Assuming a combined 40% income tax rate, what is the after-tax payback period, and what is the after-tax rate of return?

Please include detailed work.

Explanation / Answer

Cost of buying 12 million caps = $12000000*0.05

=$600000

Cost of producing 12 million caps with the machine = $12000000*0.03

=$360000

Savings = $(600000-360000)

=$240000

Payback Period = Initial Investment/Cash inflow per period

Here, the cash inflow would be the annual savings i.e $240000

Payback Period = 500000/240000

=2.08 years

Hence, the payback period is 2.08 years

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b) Annual depriciation = $500000/5

=$100000

Annual cash flow = (annual savings - depreciation)*(1- tax rate)+depreciation

=(240000-100000)*(1-40%)+100000

=$184000

Payback period = initial investment/ annual cash flow

=500000/184000

=2.72 years

Hence, the payback period is 2.72 years

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In order to calculate the after tax rate of return we need to calculate the IRR of the investent

IRR:

Hence, the rate of return is 24.49%

Year Cashflows 0 -500000 1 184000 2 184000 3 184000 4 184000 5 184000 IRR 24.49%

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