In: Accounting
America Cola is considering the purchase of a special-purpose bottling machine for $72,000. It is expected to have a useful life of 4 years with no terminal disposal value. The plant manager estimates the following savings in cash operating costs: Year Amount 1 $25,000 2 24,000 3 22,000 4 23,000 Total $94,000 America Cola uses a required rate of return of 16% in its capital budgeting decisions. Ignore income taxes in your analysis. Assume all cash flows occur at year-end except for initial investment amounts.
Required: Calculate the following for the special-purpose bottling machine: 1. Net present value 2. Payback period 3. Discounted payback period 4. Accrual accounting rate of return based on net initial investment (Assume straight-line depreciation. Use the average annual savings in cash operating costs when computing the numerator of the accrual accounting rate of return.)
1.Net Present Value:-
Year | Annual Cash Savings | PV Factor @ 16% | PV of Cash savings |
1 | 25000 | 0.8621 | 21552.50 |
2 | 24000 | 0.7432 | 17836.80 |
3 | 22000 | 0.6407 | 14095.40 |
4 | 23000 | 0.5523 | 12702.90 |
94000 | 66187.60 |
Initial Investment=72000
Net Present Value:-
=P.V. of Cash savings - Initial Investment
=66187.6 - 72000 = (5812.4)
Net present Value is negative
2.Payback Period:-
Year | Cash Savings | Cumulative Cash Savings |
1 | 25000 | 25000 |
2 | 24000 | 49000 |
3 | 22000 | 71000 |
4 | 23000 | 94000 |
Initial investment is recovered in the 4th year
Assuming even cash savings throughout the year=23000/12=1916.67 per month
=>(72000-71000)/1916.67=0.5217 month
=>0.5217/12 = 0.0435 years
Payback period = 3+0.0435 =3.0435 years
3.Discounted Payback period
Year | Cash Savings | P.V. of Cash Savings | Cumulative Cash Savings |
1 | 25000 | 21552.50 | 21552.5 |
2 | 24000 | 17836.80 | 39389.3 |
3 | 22000 | 14095.40 | 53484.7 |
4 | 23000 | 12702.90 | 66187.6 |
As per Discounted Payback period, the entire initial investment of $72000 will not be recovered as the initial investment is more than the Present Value of cash savings .Only amount of $66187.6 will be recovered in four years.
4.Accrual accounting rate of return:-
Depreciation=72000/4=18000 per annum
Average annual cash savings=94000/4=23500 per annum
Accrual Accounting rate of return=Average annual cash savings / Initial Investment
=(23500-18000) / 72000
=7.64%