Question

Chapter 8 Net Present Value/Uncertain Cash Flows Tiger Computers, Inc., of Singapore is considering the purchase of an automated etching machine for us production of its circuit boards. The machine would cost $800,000. An additional $550,000 would be required for installation costs and for software. Management believes that the automated machine wou provide substantial annual reductions in costs, as shown below: Labor costs Material costs Annual Reduction in Costs $140,000 $96,000 The new machine would require considerable maintenance work to keep it properly adjusted. The com engineers estimate that maintenance costs would increase by $5,000 per month if the machine were purchased. In addition, the machine would require an $81,000 overhaul at the end of the sixth year The new etching machine would be usable for 10 years, after which it would be sold for its scrap valu $300.000. It would replace an old etching machine that can be sold now for its scrap value of $61,0 Computers, Inc., requires a return of at least 16% on investments of this type. a) Compute the annual net cost savings promised by the new etching machine. Reduction in labor costs + Reduction in material costs = Total cost reductions - increased maintenance costs = Annual net cost savings b) Using the data from requirement (o) and other data from the problem, compute the new machine's present value. Year Cash Flow 16% Factor PV Cost of the machine Installation and software Salvage of the old machine Annual cost savings Overhaul required Salvage of the new machine Net present value

Answer 1

LUGANO'S PIZZA PARLOR

(a) SIMPLE RATE OF RETURN (SRR) = ANNUAL OPERATING INCOME FROM ASSETS / INTIAL INVESTMENT

DEPRECIATION ON PIZZA OVEN = COST OF OVEN - SCRAP VALUE / NO. OF YEARS LIFE OF OVEN

DEPRECIATION = 289000-28900 / 15

=17340 PER YEAR

ANNUAL CASH INFLOW = 144000

ANNUAL CASH OUTFLOW =86200 + 17340(DEPRECIATION) = 103540

ANNUAL OPERATING INCOME FROM ASSETS = 144000-103540 = 40460

SRR = 40460/28900 *100 =14%

(b) SIMPLE RATE OF RETURN IS MORE THAN 12% i.e. 14%. THEREFORE MR. LUGANO SHOULD PURCHASE THE OVEN AND EQUIPMENT.

(c) PAYBACK PERIOD = INTIAL INVESTMENT / NET CASH FLOW PER PERIOD

= 289000 / 40460 = 7.14 YEARS

(d) PAY BACK PERIOD OF ASSETS IS NOT LESS THAN 6 YEARS. THEREFORE MR. LUGANO SHOULD NOT PURCHASE SUCH OVEN.