Question

Maryville Cleaners has the opportunity to invest in one of two dry cleaning machines. Machine A has a four-year expected life and a cost of $30,000. It will cost an additional $6,500 to have the machine delivered and installed, and the expected residual value at the end of four years is $4,000. Machine B has a four-year expected life and a cost of $55,000. It will cost an additional $7,000 to have machine delivered and installed, and the expected residual value at the end of four years is $6,000. The company has a required rate of return of 14 percent. Additional cash flows related to the machines are as follows:

Machine A

Item	Year 1	Year 2	Year 3	Year 4
Labor savings	$25,000	$25,000	$25,000	$25,000
Power savings	1,500	1,500	1,500	1,500
Chemical savings	3,000	3,000	3,000	3,000
Additional maintenance costs	(1,200)	(1,200)	(1,200)	(1,200)
Additional miscellaneous costs	(2,500)	(2,500)	(2,500)	(2,500)

Machine B

Item	Year 1	Year 2	Year 3	Year 4
Labor savings	$32,000	$32,000	$32,000	$32,000
Power savings	2,000	2,000	2,000	2,000
Chemical savings	3.500	3,500	3,500	3,500
Additional maintenance costs	(1,500)	(1,500)	(1,500)	(1,500)
Additional miscellaneous costs	(2,700)	(2,700)	(2,700)	(2,700)

Required

1. Compute the payback period for each of the two machines.
2. Compute the net present value for each of the two machines.
3. Determine the internal rate of return for each of the two machines.
4. Which machine purchase do you recommend that the company pursue based on the results of your calculations?

Answer 1

Answer:

Machine A is recommended for purchase.

Both Machine A and Machine B has positive NPVs.

The IRRs of both machines are greater than required rate of return of 14 percent.

Company does not have any cut-off for payback period.

Out of the two machines:

Machine A has higher NPV as well as higher IRR and hence Machine A is recommended.

Workings:

Machine A installed cost = Cost of machine + Delivery and installation cost = 30000 + 6500 = $36,500

Machine B installed cost = Cost of machine + Delivery and installation cost = 55000 + 7000 = $62,000

Since there is no tax, depreciation being non-cash expenditure, the same is not considered in cash flow calculations.