Question

Wendell’s Donut Shoppe is investigating the purchase of a new $31,300 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of $5,300 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 1,300 dozen more donuts each year. The company realizes a contribution margin of $3.00 per dozen donuts sold. The new machine would have a six-year useful life.

  

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

  

Required:
1.	What would be the total annual cash inflows associated with the new machine for capital budgeting purposes?

     

2.	Find the internal rate of return promised by the new machine to the nearest whole percent.

     

3.	In addition to the data given previously, assume that the machine will have a $12,820 salvage value at the end of six years. Under these conditions, compute the internal rate of return to the nearest whole percent. (Round your final answer to nearest whole percentage.)

     

Answer 1

Ans 1:

Statement showing of annual cash inflows associated with new machine
Particulars	Amount $
Annual savings in cost (part time help)	$5,300
Additional contribution margin from expanded sales (1,300*3$)	$3,900
Annual cash inflows	$9,200

Ans 2:

Cost of new machine = $31,300

Annual cash inflows = $9,200

At IRR PV of cash out flow=PV of cash in flow

So PV Annuity factor at IRR = Initial investment / Annual cash inflows

        = $31,300 / $9,200= 3.402

Useful Life = 6 years

The PV Factor falls at 6 period nearest to interest rate 19%, therefore IRR = 19%

Ans 3:

If salvage value at 6^th year end=$12,820

Then Depreciation=cost-salvage value/useful life

31,300-12,820/6=3,080$

This Depreciation is Added to cash flows =9,200+3080

     So Annual cash flows=12,280$

So PV Annuity factor at IRR = Initial investment / Annual cash inflows

        = $31,300 / $12,280= 2.549

The PV Factor falls at 6 period nearest to interest rate 32%, therefore IRR = 32%