Question

Question 6 An investment in a robotic welder can save $1,000,000 per year in labor costs. The equipment has an expected life of five years and no market value. 1. Draw a cash-flow diagram from the company's viewpoint. 2. If the company must earn a 15% annual return on such investments, how much could be justified for the purchase of this piece of equipment? 3. If the company must earn a 20% annual return on this investment, how much could be justified for the purchase of this piece of equipment?

Answer 1

1)

The cash flow diagram of the annual savings in labor cost is shown below:-

$1,200,000 Cash flow diagram $1,000,000 $800,000 Cash flows $600,000 $400,000 $200,000 Year

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2)

The purchase price that can be justified for this equipment is equal to the present value of the savings in labor cost discounted at a rate of 15%

Present value of labor cost savings = $ 1,000,000 x PVIFA_{r=15%, n = 5 years}

Where PVIFA = Present value interest factor of annuity

Present value of labor cost savings = $ 1,000,000 x 3.352155 = $ 3,352,155

Purchase price for this piece of equipment = $ 3,352,155

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3)

If the company must earn 20% annual return, the purchase price that can be justified for this equipment is equal to the present value of the savings in labor cost discounted at a rate of 20%

Present value of labor cost savings = $ 1,000,000 x PVIFA_{r=20%, n = 5 years}

Present value of labor cost savings = $ 1,000,000 x 2.990612 = $ 2,990,612

Purchase price for this piece of equipment = $ 2,990,612