Question

A piece of labor-saving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow:

Purchase cost of the equipment	$	392,000
Annual cost savings that will be provided by the equipment	$	80,000
Life of the equipment	10 years

Required:

1a. Compute the payback period for the equipment.

1b. If the company requires a payback period of four years or less, would the equipment be purchased?

2a. Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment’s useful life.

2b. Would the equipment be purchased if the company’s required rate of return is 16%?

Answer 1

1.

A) Purchase cost of the equipment = $ 392,000 , and the annual benefit, i.e the cost saving being provided by the equipment is = $ 80000 per year.

The payback period refers to the simple, payback of the investment as a benefit in the number of years. It takes into account the number of years taken to get back the invested amount ignoring the effect of time lapsee or time value.

The formula used for Payback period calculation = Aount of Investment / Annual cash benefit.

Thus for the equipment payback period = $ 392000 / 80000 = 4.9 years.

B) If the company requires a payback period of four years or less, would the equipment be purchased ? , here when the decision is to be made only on the payback period, then the equipment should not be purchased as it takes more than 4 years to payback the initial investment.

2.

A) imple rate of return on the equipment , it is calculated based on the net operating profit or benefit after considering the effect of depreciation . and the investment amount.

Here the cost = $ 392000 , and life of assets = 10 years, and straight line method of depreciation is used,

depreciation under striaght line method =( Cost - salvage value ) useful life = ( 392000 - 0 ) 10

Depreciation per year = $ 39200 per year .

So net operating income / Benefit = Cash Benfit - Depreciation = $ 80000 - 39200 = $ 40,800.

Thus Simple rate of return = Net operaating income / Investment amount = $ 40800 / 392000 = 10.41%

.Hence simple rate of return on the equipment = 10.41%.

B) Would the equipment be purchased if the company’s required rate of return is 16% , here the companies required rate of return is more than what it is actually providing, so the company should not purchase the equipment .