Question

Sheila and The Screamers have an opportunity to invest in one of two new types of recording equipment. Type 1 requires an initial investment of $150,000 for new equipment having a four-year life and no salvage value. Type 2 requires an initial investment of $150,000 for new machinery having a five-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

                                                          Type 1      Type 2

Sales                                             $175,000 $160,000

Expenses

  Direct materials                              20,000      15,000

  Direct labor                                     32,000      33,000

  Overhead including depr.               97,500      90,000

  Selling and admin. expenses            9,000        9,000

Total expenses                                158,500    147,000

Pretax income                                  16,500    13,000

Income taxes (40%)                            6,600        5,200

Net income                                       $ 9,900    $ 7,800

Required

1. Compute the annual expected net cash flows for each type of equipment.
2. Determine the payback period for each type of equipment.
3. Compute the accounting rate of return for each type of equipment.
4. Determine the net present value for each type of equipment using 6% as the discount rate. For part (4) only, assume that cash flows occur at each year-end.
5. Identify the type of equipment you would recommend to management and explain your choice using the results of our calculations in requirements 2, 3, and 4.

Answer 1

Computation of Cash Flow After Tax- Sheila
	Type-1	Type-2
Net income	$9,900	$7,800
Add: Depreciation	$37,500	$30,000
	(150000/4)	(150000/5)
Cash Flow after tax	$47,400	$37,800

Computation of Payback period
	Initial Cost	/CFAT	=	Payback period
	Numerator	Denominator		Payback period
Type-1	$150,000.00	$47,400	=	3.16
Type-2	$150,000.00	$37,800	=	3.97
Computation of Net Present Value
Type -1
Chart values are based on:
n = 4
I = 6%
Amount	x	PV Factor	=	Present Value
$47,400.00	x	3.4651	=	$164,245.74
Less: Initial cost	=	$150,000.00
Net Present value	=	$14,245.74
Type-2
Chart values are based on:
n = 3
I = 8%
Amount	x	PV Factor	=	Present Value
$37,800	x	4.2124	=	$159,228.72
Less: Initial cost	=	150000
Net Present value	=	$9,228.72
Computation of Accounting Rate of Return
	Net Income	Average Investment	=	ARR
	Numerator	Denominator		ARR
Type-1	$47,800.00	$150,000	=	31.87%
Type-2	$37,800.00	$150,000	=	25.20%