Question

7. Capstone, Inc. (Chapter 12)

Capstone, Inc. 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, Capstone, Inc. then uses different methods to determine the best decisions for making capital outlays.

In 2020 Capstone, Inc. 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                                             $90,000                     $225,000

Salvage value now $42,000

Investment in major overhaul needed in next year    $55,000

Salvage value in 8 years                                             $15,000                       $65,000

Remaining life                                                              8 years                      8 years

Net cash flow generated each year                            $30,425                       $43,900

Instructions

1. 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.
   2. Using the payback method for each choice. (Hint: For the old machine, evaluate the payback of an overhaul.)
   3. Comparing the profitability index for each choice.
   4. Comparing the internal rate of return for each choice to the required 8% discount rate.
2. Are there any intangible benefits or negatives that would influence this decision?
3. What decision would you make and why?

Answer 1

a.

1. NPV of old equipment
Years	Particulars	Amount	PV Factor@ 8%	Present value
0	i. Initial investment (given in the question)	-55000	1	-55000
1-8	ii. Cash inflow	30425	5.75	174943.75
8	iii. Salvage value	15000	0.54	8100
	Net Present value (ii+iii-i)			128043.75
NPV of New Equipment
Years	Particulars	Amount	PV Factor@ 8%	Present value
0	i. Initial investment (given in the question = 225000-42000)	-183000	1	-183000
1-8	ii. Cash inflow	43900	5.75	252425
8	iii. Salvage value	65000	0.54	35100
	Net Present value (ii+iii-i)			104525
	Old Backhoes	New Backhoes
NPV	128043.75	104525

NPV of old equipment is higher than the new equipment. So the company should overhaul the old equipment.

2) Pay back period = Initial investment/annaul cash inflow
	Old Backhoes	New Backhoes
Pay back period	55000/30425 = 1.81years	183000/43900 = 4.17years
On the basis of Payback period, old equipment should be selected

3) Profitability index = 1+NPV/initial investment
	Old Backhoes	New Backhoes
Profitability index	=1+(128043.75/55000)= 3.33	=1+(104525/183000) = 1.57

4.  

Year	Old Backhoes	New Backhoes
0	-55000	-183000
1	30425	43900
2	30425	43900
3	30425	43900
4	30425	43900
5	30425	43900
6	30425	43900
7	30425	43900
8	30425	43900
IRR	53.53%	17.29%
IRR of Old equipment is higher than new equipment.