Question

Factor Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $511,000 cost with an expected four-year life and a $23,000 salvage value. All sales are for cash, and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

Expected annual sales of new product	$	1,850,000
Expected annual costs of new product
Direct materials		455,000
Direct labor		671,000
Overhead (excluding straight-line depreciation on new machine)		337,000
Selling and administrative expenses		168,000
Income taxes		38	%

Required:
1. Compute straight-line depreciation for each year of this new machine’s life.
2. Determine expected net income and net cash flow for each year of this machine’s life.
3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year.
4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year.
5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life.)

Answer 1

Answer:

1. Straight line depreciation:

Depreciation expense = (Initial value of machine – Salvage value) / Useful no. of years

                                           = (511,000 – 23,000) / 4

                                           = $122,000

2. Net Income:

Expected annual sales of new product	$1,850,000
Expected annual cost of new product:
Direct materials	(455,000)
Direct labor	(671,000)
Overhead (excluding straight-line depreciation on new machine)	(337,000)
Selling and administration expenses	(168,000)
Depreciation expense	(122,000)
EAT	$97,000
Tax expense	$(36860)
Net income	$60,140

               

Net cash flow:

Net cash flow = Net income + Depreciation

                          = $60,140 + $122,000

                          = $182,140

3. Machine’s payback period:

Machine’s payback period = Initial cost of machine / Annual net cash flow

                                                     = $511,000 / $182,140

                                                     = 2.8 (2 years 10 months)

4. Machine’s accounting rate of return:

Machine’s accounting rate of return = Average net income / Initial cost of machine * 100

                                                                       = $60,140 / $511,000 * 100

                                                                       = 11.76 %

5. Net present value for this machine:

Discount rate = 7%

Year	Flow	Present value	Computation
0	-511,000	-511,000
1	182,140	170,224.30	182,140 / 1.07
2	182,140	159,088.13	182,140 / 1.07^2
3	182,140	148,680.50	182,140 / 1.07^3
4	182,140 + 23,000	156,500.32	205,140 / 1.07^4

Adding up the present value column will give the net present value.

NPV = $123,493.25