Question

2. The Jones Company is evaluating a proposal to purchase a new drill press to replace a less efficient machine presently in use. The cost of the new machine, including installation, is $200,000. The machine is expected to last four years. Depreciation is computed using the straight-line method with no salvage value assumed. Pretax cash flows are expected to increase by 70,000 each year. The expected salvage value of the machine in vear 5 is $20.000 The company has a cost of capital requirement of 10%. The tax rate for the company is 20%. For this investment, compute the: a. payback period b. net present value

Answer 1

		Year 1	Year 2	Year 3	Year 4
	Pretax cash flows	$        70,000	$        140,000	$        210,000	$        280,000
Less:	Depreciation expense (200000/4)	$        50,000	$          50,000	$          50,000	$          50,000
	Pretax income	$        20,000	$          90,000	$        160,000	$        230,000
Less:	Income tax (Pretax income*20%)	$          4,000	$          18,000	$          32,000	$          46,000
	Net income	$        16,000	$          72,000	$        128,000	$        184,000
Add:	Depreciation expense	$        50,000	$          50,000	$          50,000	$          50,000
	Net cash flows after tax	$        66,000	$        122,000	$        178,000	$        234,000

	Salvage value	$        20,000
Less:	Tax @20%	$          4,000
	Salvage value after tax in year 5	$        16,000

Year	Cash flows	Cumulative Cash flows
0	$       (200,000)	$       (200,000)
1	$            66,000	$       (134,000)
2	$          122,000	$          (12,000)
3	$          178,000	$          166,000
4	$          234,000	$          400,000
Pay back period is between the year 2 and 3.
Company required to recover the 12000 from year 3 to achieve the pay back period.
Fraction of third year (12000/178000)		0.07
Payback period (2+0.07)		2.07

Year	Cash flows	PV factor @10%	Present value
0	$       (200,000)	1.00000	$        (200,000)
1	$            66,000	0.90909	$            60,000
2	$          122,000	0.82645	$          100,827
3	$          178,000	0.75131	$          133,733
4	$          234,000	0.68301	$          159,824
5	$            16,000	0.62092	$               9,935
Net present value			$          264,319