Question

Project: Evaluate the Capital Investment Scenario Shoals Corporation puts significant emphasis on cash flow when planning capital investments. The company chose its discount rate of 8 percent based on the rate of return it must pay its owners and creditors. Using that rate, Shoals Corporation then uses different methods to determine the most appropriate capital outlays. This year, Shoals Corporation is considering buying five new backhoes to replace the backhoes it now owns. 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 $200,000 Salvage value now $42,000 Investment in major overhaul needed in next year $55,000 Salvage value in 8 years $15,000 $90,000 Remaining life 8 years 8 years Net cash flow generated each year $30,425 $43,900

Instructions

1. Evaluate, discuss, and compare 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.)

Calculate the net present value of the old backhoes and the new backhoes.

Discuss the net present value of each, including what the calculations reveal about whether the company should purchase the new backhoes or continue using the old backhoes.

Calculate the payback period for keeping the old backhoes and purchasing the new backhoes. (Hint: For the old machines, evaluate the payback of an overhaul.)

Discuss the payback method and what the payback periods of the old backhoes and new backhoes reveal about whether the company should purchase new backhoes or continue using the old backhoes.

Calculate the profitability index for keeping the old backhoes and purchasing new backhoes.

Discuss the profitability index of each, including what the calculations reveal about whether the company should purchase the new backhoes or continue using the old backhoes.

2. Identify and discuss any intangible benefits that might influence this decision.

3. Answer the following: Should the company purchase the new backhoes or continue using the old backhoes?

Explain your decision.

Answer 1

Answer:

Part a. Computing the Net Present Value (NPV) of both new and old backhoes.

New backhoes

Cash inflows.

Salvage value of the old Backhoes =$42,000

Present value of the salvage value of the new backhoes =$(90,000/1.08^8) =$48,624.20

Present value of the net cash flows generated fro 8 years = 43,900*5.7466=$252,277.45

Total Present of cash inflows =42,000+48,624.20+252,277.45 =$324,901.65

Cash outflows.

Cost of the new Backhoes =$200,000

Net present value = 324,901.65 -200,000 =$142,901.65

.

Old Backhoes;

Cash inflows

Present value of salvage value of old Backhoes =(15,000/1.08^8) =$8,104.033

Present value of net cash flow generated for 8 years = 30,425*5.7466 =$174,840.31

Cash outflows

Cost of the new backhoes (investment overhaul) =$55,000

Net present value =cash inflows -cash outflows = 174,840.31 -55,000 =$119,840.31

.

Part b.

The company should buy new backhoes since the Net present value of the new backhoes is greater than the Net present value of the old backhoes.

.

Part c.

Computation of the payback period.

Payback period = Initial investment/Annual cash flows

New backhoes

Initial cost = 200,000 - 42,000 =$158,000

Annual cash flows = $43,900

Payback period = 158,000/43,900 =3.6 years

Old Backhoes

Initial cost = $55,000

Annual cash flows =$30,425

Payback period =55,000/30,425=1.8 years

Part d.

Based on the computations of the payback period above, it shows that New backhoes will take 3.6 years to payback initial investment while the old backhoes will take 1.8 years. Therefore, the company should continue using the old hoes since it has a shorter payback period.

.

Computation of the profitability index.

Profitability index = 1+(Net present value)/Initial cost

New backhoes

Profitability index = 1+ (142,901.65/158,000)

Profitability index = 1+0.904 =1.904

Old backhoes

Profitability index = 1+(119,840.31/55,000)

Profitability index =1+2.18 =3.18

.

Part e.

Based on the profitability index, the company should continue using the old backhoes since it has a higher profitability of 3.18 as compared to the new backhoes with a profitability index of 1.904.

.

Part 2.

Other intangible factors that may influence the decision include;

• The tax effect on both the old and new machine. The company should opt for an alternative with a higher tax saving or lower tax expenses.
• The depreciation expenses. The company should opt for an alternative with a lower depreciation expense to cut costs.

.

Part 3.

The company should buy the new backhoes since it has a higher NPV than the old backhoes. It makes sense to buy the new backhoes since it has a useful life of 8 years, which therefore guarantees the a higher return than old backhoes.

Additionally, In investment analysis, NPV is the most preferred tool in making the final decision whether to undertake a given project or not, and since the new backhoes has a higher NPV, the company should consider buying the new backhoes.

.

.

Explanation:

Computations Explained

Part a. Computing the Net Present Value (NPV) of both new and old backhoes.

Net present value is computed by dsicounting the annual cash flows with expected rate of return, which is also called the discount rate.

Given that the discount rate =8%

Then we proceed as follows;

New backhoes

Cash inflows.

Salvage value of the old Backhoes (it is in present form) =$42,000

.

Present value of the salvage value of the new backhoes

Discount rate = 8%, period =8 years

Hence ; Present value =Future value/(1+r)^n

where r =is the discount rate =8%

and n= is period =8 years.

Present value =$(90,000/1.08^8) =$48,624.20

.

Present value of the net cash flows generated fro 8 years

We apply the present value annuity concept

Present value of annuity factor , PVIFA = (1 - (1 + r)^-n) / r

where r =discount rate =8%

n =period =8 years

Hence;

PVIFA = (1-(1+0.08)^-8)/0.08

PVIFA =5.7466

Present value = PVIFA *Annual cash flows

Present value = 43,900*5.7466=$252,277.45

Total Present of cash inflows

=42,000+48,624.20+252,277.45 =$324,901.65

Cash outflows.

Cost of the new Backhoes =$200,000

Net present value NPV = 324,901.65 -200,000 =$142,901.65

.

Old Backhoes;

Cash inflows

Present value of salvage value of old Backhoes

Present value of the salvage value of the new backhoes

Discount rate = 8%, period =8 years

Hence ; Present value =Future value/(1+r)^n

where r =is the discount rate =8%

and n= is period =8 years.

Present value =(15,000/1.08^8) =$8,104.033

Present value of net cash flow generated for 8 years

We apply the present value annuity concept

Present value of annuity factor , PVIFA = (1 - (1 + r)^-n) / r

where r =discount rate =8%

n =period =8 years

Hence;

PVIFA = (1-(1+0.08)^-8)/0.08

PVIFA =5.7466

Present value = PVIFA *Annual cash flows

Present value = 30,425*5.7466 =$174,840.31

Cash outflows

Cost of the new backhoes (investment overhaul) =$55,000

Net present value NPV=cash inflows -cash outflows = 174,840.31 -55,000 =$119,840.31

.

Part b.

The company should buy new backhoes since the Net present value of the new backhoes is greater than the Net present value of the old backhoes. The greater the NPV, the more profitable the project is hence buying the new backhoes should be given priority over holding the old backhoes.

.

Part c.

Computation of the payback period.

Payback period = Initial investment/Annual cash flows

New backhoes

To determine the initial cost,

we take the cost of the new backhoes, less the salvage value of the old backhoes.

Initial cost = 200,000 - 42,000 =$158,000

Annual cash flows = $43,900 (provided in the question).

Payback period = 158,000/43,900 =3.6 years

Old Backhoes

To get the initial cost, we use the overhaul amount

Initial cost = $55,000

Annual cash flows =$30,425 (provided in the question)

Payback period =55,000/30,425=1.8 years

Part d.

Based on the computations of the payback period above, it shows that New backhoes will take 3.6 years to payback initial investment while the old backhoes will take 1.8 years. Therefore, the company should continue using the old hoes since it has a shorter payback period.

Computation of the profitability index.

Profitability index = 1+(Net present value)/Initial cost

New backhoes

Profitability index = 1+ (142,901.65/158,000)

Profitability index = 1+0.904 =1.904

Old backhoes

Profitability index = 1+(119,840.31/55,000)

Profitability index =1+2.18 =3.18