The Pinetop Manufacturing Company, based in Pinetop, Colorado, is one of the fas

Question

The Pinetop Manufacturing Company, based in Pinetop, Colorado, is one of the fastest growing companies in its industry. According to Mr. Bains, the company's production vice president, keeping up-to-date with technological changes is what makes the company successful. Mr. Bains feels that a machine introduced recently would fill an important need. The machine has an estimated useful life of four years, a purchase price of $240000, and a salvage value of $5000. The company controller's estimated operating results, using the new machine, follow. The company uses straight-line depreciation for all its machinery. Mr. Bains uses a 0.10 minimum desired rate of return (cost of capital) and a three-year payback period for long-term decision evaluation. Analyze the data about the machine and decide if the company should purchase it. Use the following evaluation approaches in your analysis: the accounting rate-of return method, the payback period method, and the net present value method. Summarize the information generated in (1) and make a recommendation to Mr. Bains.

Explanation / Answer

Net Cash Flow across years

Year 0 :- $240000

Year 1 :- 325,000 - 250,000 = $75,000

Year 2:- 320,000 - 250,000 = $70,000

Year 3:- 315,000 - $250,000 = 65,000

Year 4:- 310,000 - 250,000 = $60,000

Depreciation per year = (240000-5000)/4 = 58,750

Accounting Rate of Return

Average Accounting Profit = [(75,000+70,000+65,000+60,000) - (58750*4)]/4 = 8750

Initial Investment = 240,000

Accounting rate of return = 4%

Pay-Back Period

we see that the initial investment is recovered in 3.5 years (75,000 + 70,000 + 65,000 + 0.5*60,000)

Hence, pay-back period = 3.5 years

Net Present Value

Present Value of Future cash flow = (75,000/1.10^1) + (70,000/1.10^2) + (65,000/1.10^3) + (60,000/1.10^4)

= 215,849.33

Initial Investment = 240,000

NPV = -240,000 + 215,849.33 = -$24,150.70

Hence, as the payback period is more than 3 years and NPV is negative, Mr Bains should not invest in the machinery

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