Question

A piece of labor-saving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow:

Purchase cost of the equipment	$	459,000
Annual cost savings that will be provided by the equipment	$	90,000
Life of the equipment	12 years

Required:

1a. Compute the payback period for the equipment.

1b. If the company requires a payback period of four years or less, would the equipment be purchased?

2a. Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment’s useful life.

2b. Would the equipment be purchased if the company’s required rate of return is 13%?

Answer 1

Answer 1a. Computation of Payback period for the Equipment. Payback Period = Investment Required / Annual Net Cash Inflow = $459,000 / $90,000 = 5.1 years 1b. No. Equipment will not be purchased because the payback period is 5.1 years which exceeds the company's maximum payback period which is 4 years. 2a. Computation of simple rate of return on the equipment Annual Cost Savings $90,000 Less: Annual Depreciation ($459,000 / 12 years) ($38,250) Annual Incremental Net Operating Income $51,750 Simple Rate of Return = Annual Incremental Net Operating Income / Initial Investment = $51,750 / $459,000 = 11.3% 2b. No. Equipment will not be purchased because its 11.3% rate of return is less than the company's 13% required rate of return.