Question

Factor Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $479,000 cost with an expected four-year life and a $11,000 salvage value. All sales are for cash, and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.) Expected annual sales of new product $ 1,950,000 Expected annual costs of new product Direct materials 470,000 Direct labor 676,000 Overhead (excluding straight-line depreciation on new machine) 336,000 Selling and administrative expenses 175,000 Income taxes 36 % Required: 1. Compute straight-line depreciation for each year of this new machine’s life. 2. Determine expected net income and net cash flow for each year of this machine’s life. 3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year. 4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year. 5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life.)

Answer 1

1. Calculation of depreciation for each year under straight line method:

Cost of the machine = 479000

Salvage value of the machine = 11000

Life of the machine = 4 years

Depreciation = Cost - salvage value

life of the machine

= (479000 -11000) / 4

= 117000 per year

Therefore depreciation under straight line method for each of the year is 117000.

2. Calculation of expected net income for each year

Particulars	Net income ($)	Net Cash flow ($)
a. Expected annual sales	1950000	1950000
b. Less: Cost
Direct material	470000	470000
Direct labor	676000	676000
Overheads	336000	336000
Selling and administration expense	175000	175000
Depreciation for the year	117000	0
	1774000	1657000
c. Profit before tax (a-b)	176000	293000
d. Less: Taxes @ 36% ( c * 36% )	63360	105480
e. Net income / Net cash flow ( c-d )	112640	187520

3. Calculation of machine payback period

Payback period = Initial investment / Annual cash inflow

= 479000 / 187520

= 2.55 years

4. Calculation of accounting rate of return

= Profit after tax / Initial investment

Profit after tax = $ 112640

Initial investment = $ 479000

Accounting rate of return (ARR) = 112640 / 479000

= 23.52%

5. Calculation of Net Present Value (NPV)

Year	Particulars	Cash flow ($)	Disc. Rate @ 7%	Discounted Cash flow ($)
(A)	(B)	(C )	(D)	(E ) = (C*D)
0	Initial investment	-479000	1	-479000
1-4	Annual net Cash flow after tax	187520	3.39	635693
4	Salvage value	11000	0.76	635693
	Net Present Value (NPV)			792386