Cindi Collins has recently been investigating potting machines for her Gondwana

Question

Cindi Collins has recently been investigating potting machines for her Gondwana Nursery business as a way to reduce labour costs. Cindi comes to you with two options for potting machines; Machine A and Machine B. Machine A costs $60,000 and will bring a reduction in cash outflows of $15,000 for each of the next five years. At the end of that time, Machine A is expected to have a residual (salvage) value of $1,500. Machine B costs $40,000 and is expected to have a residual (salvage) value of $20,000 at the end of five years. Machine B will bring a reduction in cash outflows of $10,000 for each of years 1, 2 and 3, then a reduction in cash outflows of $2,000 in each of years 4 and 5. Gondwana Nursery’s required rate of return on investments is 8%.

(1) Calculate the payback period for options A and B. (show all working)

(2) Calculate the Net Present Value (NPV) for options A and B. (Use the present value discount factors)

Explanation / Answer

Payback period: Machine-A: Initial Investment / Annual cash inflows 60000 /15000 = 4 years Machine-B: Year Cash flows Cumulative cash inflows 0 -40000 ($40,000) 1 10000 ($30,000) 2 10000 ($20,000) 3 10000 ($10,000) 4 2000 ($8,000) 5 2000 ($6,000) Payback period is 5 years (as the investment wiwll be realised from salvage value only) Net Present value: Machine-A Year Cash flows PVF @ 8% Present value 0 -60000 1 -60000 1 15000 0.925926 13888.89 2 15000 0.857339 12860.08 3 15000 0.793832 11907.48 4 15000 0.73503 11025.45 5 16500 0.680583 11229.62 Net Present value: 911 Machine-B Year Cash flows PVF @ 8% Present value 0 -40000 1 -40000 1 10000 0.925926 9259.259 2 10000 0.857339 8573.388 3 10000 0.793832 7938.322 4 2000 0.73503 1470.06 5 22000 0.680583 14972.83 Net Present value: 2214

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