Question

Factor Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $507,000 cost with an expected four-year life and a $19,000 salvage value. All sales are for cash, and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

Expected annual sales of new product	$	1,980,000
Expected annual costs of new product
Direct materials		495,000
Direct labor		673,000
Overhead (excluding straight-line depreciation on new machine)		336,000
Selling and administrative expenses		173,000
Income taxes		34	%

Required:
1. Compute straight-line depreciation for each year of this new machine’s life.
2. Determine expected net income and net cash flow for each year of this machine’s life.
3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year.
4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year.
5. Compute the net present value for this machine using a discount rate of 6% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life.)

Answer 1

1
Straight line depreciation	(Cost - Salvage value)/Estimated useful life
Straight line depreciation	(507000-19000)/4
Straight line depreciation	$122,000
Thus, straight line depreciation each year would be $122,000
2
Calculation of expected net income is shown below
Sales revenue	$1,980,000
Less: Expenses
Direct materials	$495,000
Direct labor	$673,000
Overhead	$336,000
Selling and administrative expenses	$173,000
Depreciation	$122,000
Total expenses	$1,799,000
Income before taxes	$181,000
Taxes @ 34%	$61,540
Net income	$119,460
Cash flow each year
Net income	$119,460
Add: Depreciation	$122,000
Net cash flow	$241,460
3
Calculation of payback period is shown below
Payback period	Cost of investment/Annual net cash flow
Payback period	507000/241460
Payback period	2.10
4
Accounting rate of return	Average net income/Average investment
Average investment	(507000+19000)/2
Average investment	$263,000
Accounting rate of return	119460/263000
Accounting rate of return	45.42%
5
Annual cash flow	Present value of annuity of $1	$241,460	3.4651	$836,683.05
Salvage value	Present value of $1	$19,000	0.7921	$15,049.90
	Present value of cash inflow			$851,732.95
	Present value of cash outflow			$507,000.00
	Net present value			$344,732.95