Nancy\'s Yummy Cakes is considering installing three new industrial ovens in its

Question

Nancy's Yummy Cakes is considering installing three new industrial ovens in its newest location. The ovens cost $200,000 and have an estimated four-year useful life. She expects the ovens to have a residual value of $15,000 at the end of the four year period. She expects that the machines will increase cash revenues by $110,000 each year. In addition, electricity, insurance and maintenance expenses will increase by $22,000 per year. She has a 35% tax rate. She expects to sell the ovens at the end of the four years for a price equal to the residual value. She depreciates equipment using the striaght-line method.

1. She wants to recoup her investment in less than 3 years. Compute the payback period. Would you recommend the purchase? Why or Why not?

2. Assume she has a cost of capital of 12.5%, would you recommend that the machines be purchased? Why?

Please show work.

Explanation / Answer

1) Pay back period

= initial investment / annual after tax cash inflow

= $200000 / $73388 / year = 2.73 years

2) NPV = $29941

As the payback period is less than three years as well as the NPV id positive ($29941), the project is recommended to accept.

Note:

The depreciation = (200000 - 15000) / 4 = $46250

As the sale value of the machine at the end of the 4 years is equal to the residual value of the machine, there is no gain on sale of the machine and hence no tax has been charged on the same..

year 0 1 2 3 4 NPV cost -200000 Increase in revenue 110000 110000 110000 110000 Maintenance cost -22000 -22000 -22000 -22000 depreciation -46250 -46250 -46250 -46250 Increase in net income 41750 41750 41750 41750 Tax @ 35% -14613 -14613 -14613 -14613 After tax increase in income 27138 27138 27138 27138 depreciation 46250 46250 46250 46250 Net increase in cash flow 73388 73388 73388 73388 salvage value 15000 Total incremental after tax cash flow -200000 73388 73388 73388 88388 PV factor @12.5% 1 0.889 0.790 0.702 0.624 PV of cash flows -200000 65233 57985 51542 55180 29941

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