Chip Drayer operates a peanut farm. Chip is considering purchasing a machine tha

Question

Chip Drayer operates a peanut farm. Chip is considering purchasing a machine that will dip the peanut butter into milk chocolate. The machine would cost $120,000. Chip is determined that the new machine would increase the company's annual net cash inflows by approximately $21,000. The machine would have a 12 year useful life and no salvage value.

1) Calculate the pay-back period.

2) Calculate machine's the internal rate of return.

3) Calculate the machine's net present value using a discount rate of 10%.

4) Assuming Chip's cost of capital is 10%, is the investment acceptable? Why or why not?

Explanation / Answer

The investment is acceptable.

Pyback period = Number of years cashflow with full recovery of cost + Balance cost to be recovered/Cash flow fr the last year

In 5 years the cash flow will offset the investment upto 105000. The remaining to be recovered is 15000and the 6 th year cash flowis 21000

Hence payback period = 5+(15000/21000) = 5.71 years.

Since NPV is positive at 10%, IRR would be at a higher rate.

Take a rate of 13 and 14%

Take NPV with both these rates

IRR = A + C/(C-D) * (B-A)

A = Lower discount rate

B = higher discount rate

C = NPV at lower discount rate

D = NPV at higher discount rate

IRR = 13+ (4269.6/(4269.6--1133.7)) * (14-13)

(13+.79) * (1) = 13.79%

Year Cash Flow PV at 10% PV of cash flows Investment 0 -120000 1 -120000.00 Cash inflow 1 to 12 21000 6.8137 143087.70 NPV 23087.70

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