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Chapter 26: Q11RQ (page 1463)
What are some criticisms of the payback method?
Answer
The payback method ignores the time value of money.
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Henderson Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machineat a cost of \(1,200,000. If refurbished, Henderson expects the machine to last anothereight years and then have no residual value. Option 2 is to replace the machine at acost of \)4,600,000. A new machine would last 10 years and have no residual value.Henderson expects the following net cash inflows from the two options:
YearRefurbish CurrentPurchase New
MachineMachine
1 \( 350,000 \) 3,780,000
2 340,000 510,000
3 270,000 440,000
4 200,000 370,000
5 130,000 300,000
6 130,000 300,000
7 130,000 300,000
8 130,000 300,000
9 300,000
10 300,000
Total \( 1,680,000 \) 6,900,000
Henderson uses straight-line depreciation and requires an annual return of 10%.
Requirements
1. Compute the payback, the ARR, the NPV, and the profitability index of these twooptions.
2. Which option should Henderson choose? Why?
Using NPV to make capital investment decisions Holmes Industries is deciding whether to automate one phase of its production process. The manufacturing equipment has a six-year life and will cost \(910,000.
Year 1 \) 262,000 Year 2 254,000 Year 3 222,000 Year 4 215,000 Year 5 200,000 Year 6 175,000 |
Requirements
Holmes could refurbish the equipment at the end of six years for \(104,000. The refurbished equipment could be used one more year, providing \)77,000 of net cash inflows in year 7. Additionally, the refurbished equipment would have a $55,000 residual value at the end of year 7. Should Holmes invest in the equipment and refurbish it after six years? (Hint: In addition to your answer to Requirement 1, discount the additional cash outflow and inflows back to the present value.)
How is payback calculated with unequal net cash inflows?
Splash Nation is considering purchasing a water park in Atlanta, Georgia, for \(1,910,000. The new facility will generate annual net cash inflows of \)483,000 foreight years. Engineers estimate that the facility will remain useful for eight years andhave no residual value. The company uses straight-line depreciation, and its stockholdersdemand an annual return of 10% on investments of this nature.
Requirements
1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index ofthis investment.
2. Recommend whether the company should invest in this project.
Using the time value of money Helen wants to take the next four years off work to travel around the world. She estimates her annual cash needs at $31,000 (if she needs more, she will work odd jobs). Helen believes she can invest her savings at 10% until she depletes her funds. Requirements
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