Ogemaw, Inc. is an OEM (original equipment manufacturer) that is considering add

Question

Ogemaw, Inc. is an OEM (original equipment manufacturer) that is considering adding a new product line - either snow plow attachments for pick-up trucks (Proposal A) or truck toppers with cargo boxes (Proposal B). To do so, it will need to invest in new equipment. Ogemaw has gathered the following information about each proposal: Proposal A's equipment will cost $8,530,000 and is expected to result in annual net cash inflows of $1,545,000 over nine years, with zero residual value at the end of nine years. Proposal B's equipment will cost $7,850,000 and is expected to generate net cash inflows of $970,000 per year for nine years. Estimated residual value for Plan B is $1,075,000. Ogemaw, Inc. uses straight-line depreciation and requires an annual rate of return of 6%.

Note: At a 6% discount rate, the present value of annuity of $1 for 9 years is 6.802, and the present value of $1 for 9 years is 0.592.

Answer the following questions. Each question is worth 1 point.

1. Compute payback period for Proposal A (round answer to one decimal place):

2. Compute accounting rate of return for Proposal B (calculate answer to three decimal places; for example, enter 11.8% as 0.118):

3. Compute net present value (NPV) for Proposal B. Enter as a positive number if NPV is positive, otherwise as a negative. (round answer to the nearest dollar):

4. What is the internal rate of return (IRR) for Proposal A? Enter as a percentage not decimal; e.g., 8.12 not .0812

Explanation / Answer

1) Payback period is the no. of years it takes to recover investment

For A, Payback Period = Investment / Annual cash flows = 8,350,000 / 1,545,000 = 5.52 years

2) AAR = Net Income / Investment = (Cash Flows - Depreciation) / Investment

For B, Depreciation = Investment / No. of years = 7,850,000 / 9 = 872,222

Net Income = 970,000 - 872,222 = 97,778 => AAR = 97,778 / 7,850,000 = 1.25%

3) NPV = PV of cash inflows - Initial Investment

For B, NPV = 0.592 x 1,075,000 + 6.802 x 970,000 - 7,850,000 = -615,660

4) IRR can be calculated using I/Y function on a calculator

N = 9, PMT = 1,545,000, PV = -8,530,000, FV = 0 => Compute IRR = 11.07%

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