Waterways Corporation puts much emphasis on cash flow when it plans for capital
ID: 2744399 • Letter: W
Question
Waterways Corporation puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 8% based on the rate of return it must pay its owners and creditors. Using that rate, Waterways Corporation then uses different methods to determine the best decisions for making capital outlays.
In 2014 Waterways Corporation is considering buying five new backhoes to replace the backhoes it now has. The new backhoes are faster, cost less to run, provide for more accurate trench digging, have comfort features for the operators, and have 1-year maintenance agreements to go with them. The old backhoes are working just fine, but they do require considerable maintenance. The backhoe operators are very familiar with the old backhoes and would need to learn some new skills to use the new backhoes.
The following information is available to use in deciding whether to purchase the new backhoes.
Old Backhoes
New Backhoes
Purchase cost when new
$90,000
$200,000
Salvage value now
$42,000
Investment in major overhaul needed in next year
$55,000
Salvage value in 8 years
$15,000
$90,000
Remaining life
8 years
8 years
Net cash flow generated each year
$30,425
$43,900
Instructions
(4) Comparing the internal rate of return for each choice to the required 8% discount rate.
(b) Are there any intangible benefits or negatives that would influence this decision?
(c) What decision would you make and why?
Old Backhoes
New Backhoes
Purchase cost when new
$90,000
$200,000
Salvage value now
$42,000
Investment in major overhaul needed in next year
$55,000
Salvage value in 8 years
$15,000
$90,000
Remaining life
8 years
8 years
Net cash flow generated each year
$30,425
$43,900
Explanation / Answer
(4) (a) The IRR (as calculated below) for Old backhoes = 41.71% and for New Backhoes it is 18.42%. Both are greater than the 8% required discount rate and hence acceptable. But, since the two projects are mutually exclusive, the one with the highest IRR should be chosen. Old Backhoes should be the option as it has a higher IRR. OLD BACKHOES: 1 2 3 4 5 6 7 8 Cumulative Yearly net cash inflows 30425 30425 30425 30425 30425 30425 30425 30425 Major overhaul -55000 Salvage value 15000 30425 -24575 30425 30425 30425 30425 30425 45425 pvif @ 25% 0.8000 0.6400 0.5120 0.4096 0.3277 0.2621 0.2097 0.1678 PV @ 25% 24340 -15728 15578 12462 9970 7976 6381 7621 68599 pvifa @ 40% 0.7143 0.5102 0.3644 0.2603 0.1859 0.1328 0.0949 0.0678 PV @ 40% 21732 -12538 11088 7920 5657 4041 2886 3078 43864 pvifa @ 42% 0.7042 0.4959 0.3492 0.2459 0.1732 0.1220 0.0859 0.0605 pv @ 42% 21426 -12188 10626 7483 5270 3711 2613 2748 41689 The IRR lies between 40% & 42%--Initial investment to be considered as $42000, beng the opportunity cost. The exact IRR = 40 + 2(43864-42000)/(43864-41689) = 41.71 % NEW BACKHOES: 1 2 3 4 5 6 7 8 Cumulative Yearly net cash inflows 43900 43900 43900 43900 43900 43900 43900 43900 Salvage value 90000 43900 43900 43900 43900 43900 43900 43900 133900 pvif @ 15% 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 PV @ 10% 38174 33195 28865 25100 21826 18979 16504 43772 226415 pvifa @ 18% 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704 0.3139 0.2660 PV @ 18% 37203 31528 26719 22643 19189 16262 13781 35623 202949 pvifa @ 19% 0.84034 0.7062 0.59342 0.49867 0.41905 0.352142 0.29592 0.248671 pv @ 19% 36891 31001 26051 21892 18396 15459 12991 33297 195977 The IRR lies between 18% & 19% The exact IRR = 18 +(202949-200000)/(202949-195977) = 18.42 % [b]) The new backhoes are more accurate and have comfort features for the operators; but workers need training, As regards the old back hoes the advantage lies in the workers being familiar with the equipment. [c] The decision is to continue with the Old backhoes as its IRR is much higher than the new backhoes.
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