Garrett Boone, Farish Enterprises’ vice president of operations, needs to replac

Question

Garrett Boone, Farish Enterprises’ vice president of operations, needs to replace an automatic lathe on the production line. The model he is considering has a sales price of $289,225 and will last for 9 years. It will have no salvage value at the end of its useful life. Garrett estimates the new lathe will reduce raw materials scrap by $39,500 per year. He also believes the lathe will reduce energy costs by $26,250 per year. If he purchases the new lathe, he will be able to sell the old lathe for $6,303. Click here to view the factor table. (a) Calculate the lathe’s internal rate of return If Farish Enterprises uses a 15% hurdle rate, should Garrett purchase the lathe?

Explanation / Answer

Cash flow at 0 period = Purchase Price of New Lathe - Sale Price of Old Lathe

= 289225 - 6303

= $282922

Cash flow per year = Savings in material srcap + Savings in energy costs

= 39500 + 26250

= $65750

NPV @ 15% = Present Value of Cash inflows - Present Value of Cash outflows

= [65750 x 4.772] - 282922

= $30837

NPV @ 20% = Present Value of Cash inflows - Present Value of Cash outflows

= [65750 x 4.031] - 282922

= -$17884

Internal Rate of Return = Lower rate + [Lower rate NPV / (Lower rate NPV - Higher rate NPV) ] x Difference in rates

= 15 + [30837 / (30837+17884)] x 5

= 18.16%

If Farish Enterprises uses a 15% hurdle rate, Garrett should purchase the lathe as the NPV at 15% is positive.

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