Exercise-10 (Payback period method with salvage value)

The Black Stone company sells crushed stone to government contractors as well as to small business owners involved in construction business. The company needs to replace an old equipment with a new one. The new equipment can increase production as well as improve the quality of crushed stone. The information about annual incremental revenues and costs associated with the new equipment is given below:

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The only non-cash expense in the above income statement is the depreciation. The new equipment would cost $240,000 and the old equipment can be sold to a small company for its salvage value of $15,000.

Required: Would the company invest in new equipment if the desired payback period is 2.5 years or less?

Solution:

Step 1 Computation of net annual cash inflow:

The net operating income is not equal to net cash flow because it has been obtained after taking into account the depreciation – a non-cash expense. We would add the depreciation back to net operating income to get the incremental net cash inflow figure. It is shown below:

$60,000 + $30,000 = $90,000

Step 2: Computation of investment:

The price of new equipment is $240,000 and the salvage value of the old equipment is $15,000. The required investment is, therefore, $225,000 ($240,000 – $15,000).

Step 3: Computation of payback period:

Payback period = Investment required for the project/Net annual cash inflow

= $225,000/$90,000

= 2.5 years

The equipment promises a payback period of 2.5 years that is equal to the maximum desired payback period of the company. The equipment would, therefore, be purchased.

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