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America Cola is considering the purchase of a special-purpose bottling machine for $72,000. It is expected...

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.)

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Expert Solution

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%


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