Heartland Paper Company is considering the purchase of a newhigh-speed cutting m

Question

Heartland Paper Company is considering the purchase of a newhigh-speed cutting machine. Tow cutting machine manufacturers haveapproached Heartland with proposals: (1) Toledo Tools and (2) AkronIndustries. Regardless of which vendor Heartland chooses, thefollowing incremental cash flows are expected to be realized:

Year                                                                             IncrementalCash             Incremental Cash

                                                                                             Inflows                            Outflows     

1…………………………………………………….            $26,000                      $20,000

2…………………………………………………….            27,000                        21,000

3…………………………………………………….            32,000                        26,000

4…………………………………………………….            35,000                        29,000

5…………………………………………………….            34,000                        28,000

6…………………………………………………….            33,000                        27,000

a.      If the machinemanufactured by Toledo Tools costs $27,000, what is its expectedpayback period?

b.      If the machinemanufactured by Akron Industries has a payback period of 66 months,what is its cost?

c.       Which ofthe machines is most attractive based on its respective paybackperiod? Should Heartland base its decision entirely on thiscriterion? Explain your answer.

Explanation / Answer

1. First calculate Net Cash Inflow = Cash Inflow-Cash Outflow.We find that Net cash Inflow is $6000 per year. (26000-20000) &so on.
Payback period is the time needed to recover investment. So Payback period = 6000+6000+6000+6000+3000/6000 = 27000.This is happening in 4.5 years. So Payback period is 4.5 Years. It can also be calculated by using formula Payback period= Total Investment/Annual Cash flow = 27000/6000 = 4.5 Years =4.5x12 = 54 months 2. If Payback period is 66 months, Its cost = Payback period xAnnual cash flow = (66/12) * 6000 = $33000 So cost of machine is $33,000 3. Based on payback period, Toledo tools is better as it ischaeper & hence has a faster payback period. However we need to find the NPV of the project to decide onthe machine. For this, we also need to know the cost ofcapital. Assuming Cost of capital as 12%, when we use Excel NPVfunction to find the NPV of current project with given Cash flows,we find that for Toledo, NPV = - 2081.75 & for Akron, NPV =-7438.89. Thus both machines have a Neative NPV. So the business mgr hasto decide whether to buy any of the above machines or look forother cheaper options.

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