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 $503,000 cost with an expected four-year life and a $23,000 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 $ 1,840,000 Expected annual costs of new product Direct materials 485,000 Direct labor 671,000 Overhead (excluding straight-line depreciation on new machine) 337,000 Selling and administrative expenses 162,000 Income taxes 38 % 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.)

Determine expected net income and net cash flow for each year of this machine’s life.

Answer 1

1) Straight Line Depreciation = (Initial Investment of Machine - Salvage Value) / Years of estimated life

= ($ 503,000- $ 23,000) / 4 Years

= $ 120,000

2) Expected net income and net cash flow for each year of this machine’s life

Expected Net Income
Revenues		1,840,000
Expenses
Direct Materials	485,000
Direct Labour	671,000
Overhead excluding straight line depreciation on new machine	337,000
Selling & administrative expenses	162,000
Total Expenses		1,655,000
Income Before Taxes		185,000
Tax on Income @ 38%		70,300
Net Income after Tax		114,700
Net Cash Flow
Net Income after Tax		114,700
Straight line depreciation on new machine		120,000
Net Annual Cash Flow		234,700

3) Payback Period = Cost of Investment / Net Annual Cash Flow

= $ 503,000 / 234,700

= 2.14 Years

4) Machine’s accounting rate of return = (Average Annual Net Income / Initial Investment) * 100

= ($ 114,700 / $ 503,000) * 100

= 23%

5) NPV of the project is as follows:

NPV of Project @ 7% Discount Rate
Cash Flow	Year 0	Year 1	Year 2	Year 3	Year 4
Initial Investment	(503,000)
Annual Cash Inflow	-	234,700	234,700	234,700	234,700
Salvage Value					23,000
Total Cash Flow	(503,000)	234,700	234,700	234,700	257,700
PV Factor	1	0.9346	0.8734	0.8163	0.7629
Present Value of Cash Flow	(503,000)	219,346	204,996	191,585	196,598
Cumulative Cash Flow	(503,000)	(283,654)	(78,658)	112,927	309,525