Question

Question #4 Your company has a piece of equipment that is getting old. The company that sold the equipment to you has offered to replace the equipment with something better. The salesman has provided the following information: New Equipment Cost Expected increased cash flow Salvage value of old equipment Salvage value of new equipment Life expectancy Required rate of return Required payback period $1,500,000 $200,000 per year $20,000 $100,000 10 years 10% 8 years Required: Should you buy the new equipment, or continue to use the old? Use the payback period method to make your decision. a) b) Calculate the Accounting Rate of Return. c) If the methods do not agree, should you make the investment?

The depreciation method used is straight line.

Answer 1

a]

New equipment cost is $1.5 million

expected increased cash flow is$200,000 per year

payback period is the time taken by the cash inflows to equal the initial investment

payback period = $1.5 million / $200,000 ==>   7.5 years

The required payback period is 8 years. The expected actual payback period is 7.5 years, which is less than the required payback period. Hence, the new equipment should be bought

b]

Accounting rate of return = net income / asset cost

ARR = $200,000 / $1.5 million

ARR = 0.1333, or 13.33%

c]

If the methods do not agree, it is better to select one method which better reflects the company's profit goals. Payback period focuses on faster recovery of capital, whereas ARR focuses on rate of return. Both are two sides of the same coin, as each ratio is a reciprocal of the other. So as long as the required rate of return and required payback period are consistently determined, both methods should agree.