Question

Waterways Continuing Problem 12 a

Waterways puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 8% based on the rate of return it must pay its owners and creditors. Using that rate, Waterways then uses different methods to determine the best decisions for making capital outlays.

This year Waterways is considering buying five new backhoes to replace the backhoes it now has. The new backhoes are faster, cost less to run, provide for more accurate trench digging, have comfort features for the operators, and have 1-year maintenance agreements to go with them. The old backhoes are working just fine, but they do require considerable maintenance. The backhoe operators are very familiar with the old backhoes and would need to learn some new skills to use the new backhoes.

The following information is available to use in deciding whether to purchase the new backhoes.

		Old Backhoes		New Backhoes
Purchase cost when new		$88,500		$204,128
Salvage value now		$42,400
Investment in major overhaul needed in next year		$54,180
Salvage value in 8 years		$14,800		$92,000
Remaining life		8 years		8 years
Net cash flow generated each year		$30,100		$44,800

Click here to view PV table.

(a) Evaluate in the following ways whether to purchase the new equipment or overhaul the old equipment. (Hint: For the old machine, the initial investment is the cost of the overhaul. For the new machine, subtract the salvage value of the old machine to determine the initial cost of the investment.)

(1) Using the net present value method for buying new or keeping the old. (For calculation purposes, use 5 decimal places as displayed in the factor table provided. If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round final answer to 0 decimal places, e.g. 5,275.)

		New Backhoes		Old Backhoes
Net Present Value		$		$

Waterways should buy New Backhoesretain Old Backhoes equipment.

(2) Using the payback method for each choice. (Hint: For the old machine, evaluate the payback of an overhaul.) (Round answers to 2 decimal places, e.g. 1.25)

		New Backhoes		Old Backhoes
Payback Period		years		years

Waterways should buy New Backhoesretain Old Backhoes equipment.

(3) Comparing the profitability index for each choice. (Round answers to 2 decimal places, e.g. 1.25)

		New Backhoes		Old Backhoes
Profitability Index

Waterways should buy New Backhoesretain Old Backhoes equipment.

Calculate the internal rate of return factor for the new and old blackhoes. (Round answers to 5 decimal places, e.g. 5.27647.)

		New Backhoes		Old Backhoes
IRR Factor

(4) Comparing the internal rate of return for each choice to the required 8% discount rate.

Waterways should buy New Backhoesretain Old Backhoes equipment.

Answer 1

(a)

(1)  Calculation of Net present value in case of buying the new backhoes.

Particulars	Amount ($)
Salvage value of old backhoes	42,400
Present cash flows of 8 years (44800*5.74)	257152
Present salvage value of new backhoes (88500*0.54)	47790
A. Total cash inflows	3,47,342
B. Cost of new backhoes	-2,04,128
Net Present value (A-B)	1,43,214

Net present value of keeping the old backhoes

Particulars	Amount ($)
Present cash flows of 8 years (30100*5.74)	1,72,774
Present salvage value of old backhoes (14800*0.54)	7992
A. Total cash inflows	1,80,766
B. Investment in next year	-54,180
Net Present value (A-B)	1,26,586

Net present value of new backhoes is greater than the Net present value of keeping the old backhoes. Hence, Waterways should buy the New backhoes.

(2) Calculation of Payback period :

Particulars	Old Backhoes	New Backhoes
A. Initial Cost	54,180	1,61,728
		(204128-42400)
B. Annual Cashflows	30,100	44,800
Payback Period (A/B)	1.8 years	3.6 years

New blackhoes payback period is more than old backhoes. Hence, Old backhoes is to be retained.

(3)  Calculation of Probability index

Particulars	Old Backhoes	New Backhoes
A. Present value of cash flows	1,80,766	2,99,552
B. Cash Outflow	54,180	2,04,128
Profitability Index (A/B)	3.34	1.47

Old backhoes is to be retained since it has higher profitability index.

Internal Rate of Return

For New Backhoes,

First discounting rate is 8% and assuming second discount rate @9%.

Calculation of Net present value @9%

Particulars	Amount ($)
Salvage value of old backhoes	42,400
Present cash flows of 8 years (44800*5.53)	2,47,744
Present salvage value of new backhoes (88500*0.50)	44,250
A. Total cash inflows	3,34,394
B. Cost outflow	-2,04,128
NPV @ 9%	1,30,266
NPV @ 8% (Point (1))	1,43,214

Internal rate of return of New Backhoes =

L1 = lowest discount rate, L2 = Highest discount rate

Irr = 8% + [(143214 )/ (130266 - 143214) ] (9-8)

= 8% - 143214/12,948 * 1

= 8% - 11.06% = - 3.06%

Particulars	Amount ($)
Present cash flows of 8 years (30100*5.53)	1,66,453
Present salvage value of old backhoes (14800*0.50)	7,400
A. Total cash inflows	1,73,853
B. Cost outflow	-54,180
NPV @ 9%	1,19,673
NPV @ 8% (Point (1))	1,26,586

Internal rate of return = 8% + 126586 /(119673 -126586) * (9-8)

= 8% - 127660/6931* 1

=8% - 18.31 = -10.31%

(4) If the Internal rate of return is greater than the cost of capital, the project is to be pursued. But the internal rate of return of 2 projects is in negative that is the cash flows is less than the initial investment.

And IRR is not to be trusted in taking a decision. Waterways may face negative returns by considering IRR.