Question

Johnson Company is considering purchasing one of two new machines. The following estimates are available for each machine:

		Machine 1			Machine 2
Initial cost		$152,000			$169,000
Annual cash inflows		50,000			60,000
Annual cash outflows		15,000			20,000
Estimated useful life		6 years			6 years

The company's minimum required rate of return is 9%.

		Present Value of an Annuity of 1
Period		8%		9%		10%		11%		12%		15%
6		4.623		4.486		4.355		4.231		4.111		3.784

Requirement:

Compute Payback, NPV, PI, and IRR for both machine options? Which machine should be selected? Show your work.

Answer 1

solution:

Payback period = Initial investment / Annual cash inflows

Machine 1 = $152,000 / $35,000 = 4.34 years

Machine 2 = $169,000 / $40,000 = 4.23 years

Computation of NPV
			Machine 1		Machine 2
Particulars	Period	PV Factor	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$152,000	$152,000	$169,000	$169,000
Present Value of Cash outflows (A)				$152,000		$169,000
Cash Inflows
Annual cash inflows	1-6	4.486	$35,000	$157,010	$40,000	$179,440
Present Value of Cash Inflows (B)				$157,010		$179,440
Net Present Value (NPV) (B-A)				$5,010		$10,440

Computation of Profitability Index
Particulars	Machine 1	Machine 2
NPV	$5,010	$10,440
Initial investment	$152,000	$169,000
Profitability Index (PV of cash inflows / Initial investment)	0.03	0.06

Computation of IRR
Period	Machine 1		Machine 2
	Cash Flows	IRR	Cash Flows	IRR
0	-$152,000.00	10.1%	-$169,000.00	11.0%
1	$35,000.00		$40,000.00
2	$35,000.00		$40,000.00
3	$35,000.00		$40,000.00
4	$35,000.00		$40,000.00
5	$35,000.00		$40,000.00
6	$35,000.00		$40,000.00

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On the basis of above analysis, machine 2 should be selected.