Question

Choo Choo Inc. is a manufacturer of model trains. The company is considering the purchase of an industrial 3D printer, which will allow the firm to produce custom-made model trains for its high-end customers. The printer will cost $2,500,000, and it is expected to produce net cash flows of $600,000 per year for the next six years. Liquidation of the equipment will net the firm $350,000 in cash at the end of six years. The firm requires a 15% rate of return on all investments. Ignore the effects of taxes.                                                                              (12 marks total)

a. What is the payback period for the proposed investment in the 3D printer? Provide your answer in number of years and months.                                   (1 mark)

b. What is the printer’s discounted payback period? Provide your answer in number of years and months.                                                            

c.   Choo Choo’s cutoff period is set at five years. Based on the payback period investment criterion, will the company purchase the printer? Will it purchase the printer based on the discounted payback period investment criterion?                                     (1 mark)

d. What is the printer’s net present value (NPV)? Should the company purchase the printer based on the NPV investment criterion?                                (2.5 marks)

e. What is the printer’s profitability index (PI)? Should the company purchase the printer based on the PI investment criterion?                                    (1.5 marks)

f.   What is the printer’s internal rate of return (IRR)?                       

g. Check that at the internal rate of return (IRR) the net present value of the printer is $0. Should the company purchase the printer based on the IRR investment criterion?                                                (1.5 marks)

h.       Based on your answers in parts a to f above, what decision do you recommend for Choo Choo?          

Answer 1

Based on the given data, pls find below steps, workings and the answers:

a. What is the payback period for the proposed investment in the 3D printer? Provide your answer in number of years and months. Payback is 50 months and 4.17 years

b. What is the printer’s discounted payback period? Provide your answer in number of years and months. Discounted Payback is more than 72 months and 6 years

c.   Choo Choo’s cutoff period is set at five years. Based on the payback period investment criterion, will the company purchase the printer? Will it purchase the printer based on the discounted payback period investment criterion?                                     If the cut-off period is five years, then based on the Payback criteria, it is recommeded for purchase of printer; However, the same is not recommended based on the discounted Payback period;

d. What is the printer’s net present value (NPV)? Should the company purchase the printer based on the NPV investment criterion? The NPV of this Printer is negative $ 77995.73 and based on this, it is not recommended for the company to purchase this printer.

e. What is the printer’s profitability index (PI)? Should the company purchase the printer based on the PI investment criterion? The Profitability Index is negative 3.12% and based on this, it is not recommended for the company to purchase this printer.

f.   What is the printer’s internal rate of return (IRR)? The Internal Rate of Return is 13.90%, lower than that of the discounting factor (requried rate of return) and based on this, it is not recommended for the company to purchase this printer.

g. Check that at the internal rate of return (IRR) the net present value of the printer is $0. Should the company purchase the printer based on the IRR investment criterion? At Internal Rate of Return the NPV of the Printer is 0.   

h.       Based on your answers in parts a to f above, what decision do you recommend for Choo Choo?          

Based on the above criterion, it is not recommended for the company to purchase this printer.

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Pay Back Period: Here, the period is computed for each project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.