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 $487,000 cost with an expected four-year life and a $19,000 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	$	1,930,000
Expected annual costs of new product
Direct materials		480,000
Direct labor		670,000
Overhead (excluding straight-line depreciation on new machine)		338,000
Selling and administrative expenses		154,000
Income taxes		30	%

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.)

Answer 1

Solution 1:

Straight line depreciation = ($487000- $19000) / 4 = $117000

Solution 2:

Expected Net Income
Revenues:
Sales		$1930000
Expenses:
Direct Materials	$480000
Direct Labor	670000
Overhead excluding depreciation	338000
Selling and administrative expenses	154000
Straight line depreciation	117000
Total Expenses		1759000
Income before taxes		$171000
Income tax expense (30%)		51300
Net Income		$119700
Expected net Cash Flow
Net Income		$119700
Add: Straight line Depreciation		117000
Net Cash Flow		$236700

Solution 3:

Payback Period = Cost of investment / Annual net Cash flow

Payback Period = $487000 / $236700 = 2.06 years

Solution 4:

Accounting rate of Return = Annual Net Income after tax / Average Investment

Average Investment = ( 487000 + 19000 ) / 2 = 253000

Accounting rate of Return = 119700 / 253000 = 0.47 or 47%

Solution 5:

n=	4
i=	7%
PVA of $1, 7%, 4	3.3872
PV of $1, 7%, 4	0.7629

Cash Flow	Amount	PV Factor	Present Value
Annual cash Flow	236700	3.3872	$801750.24
Residual Value	19000	0.7629	14495.1
Total			$816245.34

NPV = PV of Cash flow - Initial investment

Present value of cash flow	$816245
Less: Initial investment	487000
Net Present Value	$329245