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Horngren'S Financial And Managerial Accounting
Found in: Page 1474

Short Answer

Using payback, ARR, and NPV with unequal cash flows

Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of $2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of $3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:

Year

Refurbish current machine

Purchase new machine

1

$1,760,000

$2,970,000

2

440,000

490,000

3

360,000

410,000

4

280,000

330,000

5

200,000

250,000

6

200,000

250,000

7

200,000

250,000

8

200,000

250,000

9

250,000

10

250,000

Total

$3,640,000

$5,700,000

Hughes 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 two options.

2. Which option should Hughes choose? Why?

  1. Capital budgeting calculations:

Method

Refurbish current machine

Purchase new machine

Payback

3.86 years

3 years

ARR

10%

10%

NPV

$257,880

$581,520

Profitability index

1.10

1.15

2. The business entity must select the option of purchasing a new machine.

See the step by step solution

Step by Step Solution

Step 1: Definition of Payback Period

A capital budgeting metric that determines the time period in which the investment will give back the cash invested or the investment/cash recovery period is known as the payback period.

Step 2: Calculation of payback period, ARR, NPV, and profitability index

Calculation of payback period:

1. Refurbishment of current machine:

2. Purchase of new machine:

Working note:

Year

Refurbish current machine

Cumulative

Purchase new machine

Cumulative

1

$1,760,000

$1,760,000

$2,970,000

$2,970,000

2

440,000

$2,200,000

490,000

$3,460,000

3

360,000

$2,560,000

410,000

$3,870,000

4

280,000

$2,840,000

330,000

5

200,000

250,000

6

200,000

250,000

7

200,000

250,000

8

200,000

250,000

9

250,000

10

250,000

Total

$3,640,000

$5,700,000

Calculation of ARR:

  1. Refurbishment of machine:

Working note:

Particular

Amount $

Total net cash flows during the life of the project

$3,640,000

Less: Total depreciation during the life of the asset

2,600,000

Total operating income during the operating life

$1,040,000

Asset operating life in years

8

Average annual operating income

$130,000

2. Purchase a new machine:

Working note:

Particular

Amount $

Total net cash flows during the life of the project

$5,700,000

Less: Total depreciation during the life of the asset

3,800,000

Total operating income during the operating life

$1,900,000

Asset operating life in years

10

Average annual operating income

$190,000

Calculation of NPV:

  1. Refurbish of current machine:

Year

Refurbish current machine

X

Present value factor

=

Present value

1

$1,760,000

X

0.909

=

$1,599,840

2

440,000

X

0.826

=

$363,440

3

360,000

X

0.751

=

$270,360

4

280,000

X

0.683

=

$191,240

5

200,000

X

0.621

=

$124,200

6

200,000

X

0.564

=

$112,800

7

200,000

X

0.513

=

$102,600

8

200,000

X

0.467

=

$93,400

Total present value of net cash inflow$2,857,880
Less: initial investment(2,600,000)
Net present value$257,880

2. Purchase of new machine:

Year

Purchase new machine

X

Present value factor

=

Present value

1

$2,970,000

X

0.909

=

$2,699,730

2

490,000

X

0.826

=

$404,740

3

410,000

X

0.751

=

$307,910

4

330,000

X

0.683

=

$225,390

5

250,000

X

0.621

=

$155,250

6

250,000

X

0.564

=

$141,000

7

250,000

X

0.513

=

$128,250

8

250,000

X

0.467

=

$116,750

9

250,000

X

0.424

=

$106,000

10

250,000

X

0.386

=

$96,500

Total present value net cash inflow$4,381,520
Less: initial investment(3,800,000)
Net present value$581,520

Calculation of profitability index:

1. Refurbish current machine:

2. Purchase of new machine:

Step 3: Appropriate option

The business entity must purchase a new machine because its payback period is lower, and NPV and profitability index are higher than the current machine’s refurbishing.

Most popular questions for Business-studies Textbooks

Spencer Wilkes is the marketing manager at Darby Company. Last year, Spencer recommended the company approve a capital investment project for the addition of a new product line. Spencer’s recommendation included predicted cash inflows for five years from the sales of the new product line. Darby Company has been selling the new products for almost one year. The company has a policy of conducting annual post audits on capital investments, and Spencer is concerned about the one-year post-audit because sales in the first year have been lower than he estimated. However, sales have been increasing for the last couple of months, and Spencer expects that by the end of the second year, actual sales will exceed his estimates for the first two years combined.

Spencer wants to shift some sales from the second year of the project into the first year. Doing so will make it appear that his cash flow predictions were accurate. With accurate estimates, he will be able to avoid a poor performance evaluation. Spencer has discussed his plan with a couple of key sales representatives, urging them to report sales in the current month that will not be shipped until a later month. Spencer has justified this course of action by explaining that there will be no effect on the annual financial statements because the project year does not coincide with the fiscal year––by the time the accounting year ends, the sales will have actually occurred.

Requirements

1. What is the fundamental ethical issue? Who are the affected parties?

2. If you were a sales representative at Darby Company, how would you respond to Spencer’s request? Why?

3. If you were Spencer’s manager and you discovered his plan, how would you respond?

4. Are there other courses of action Spencer could take?

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