Waterways puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 7% based on the rate of return it must pay its owners and creditors. Using that rate, Waterways then uses different methods to determine the best decisions for making capital outlays. This year Waterways is considering buying five new backhoes to replace the backhoes it now has. The new backhoes are faster, cost less to run, provide for more accurate trench digging, have comfort features for the operators, and have 1-year maintenance agreements to go with them. The old backhoes are working just fine, but they do require considerable maintenance. The backhoe operators are very familiar with the old backhoes and would need to learn some new skills to use the new backhoes. The following information is available to use in deciding whether to purchase the new backhoes. Old Backhoes New Backhoes

Purchase cost when new $90,000 $200,000

Salvage value now $42,000

Investment in major overhaul needed in next year $55,000

Salvage value in 8 years $15,000 $90,000

Remaining life 8 years 8 years

Net cash flow generated each year $30,425 $43,900

Instructions

(a) Evaluate in the following ways whether to purchase the new equipment or overhaul the old equipment. (Hint: For the old machine, the initial investment is the cost of the overhaul. For the new machine, subtract the salvage value of the old machine to determine the initial cost of the investment.)

(1) Using the net present value method for buying new or keeping the old.

(2) Using the payback method for each choice. (Hint: For the old machine, evaluate the payback of an overhaul.)

(3) Comparing the profitability index for each choice.

(4) Comparing the internal rate of return for each choice to the required 8% discount rate.

(b) Are there any intangible benefits or negatives that would influence this decision?

(c) What decision would you make and why?

(a) Evaluate in the following ways whether to purchase the new equipment or overhaul the old equipment.  

(1) Using the net present value method for buying new or keeping the old.

(2) Using the payback method for each choice.

(3) Comparing the profitability index for each choice.

(4) Comparing the internal rate of return for each choice to the required 7% discount rate.

(b) Are there any intangible benefits or negatives that would influence this decision?

(c) What decision would you make and why?

Explanation:

                                                   Old Backhoes           New Backhoes

Purchase cost when new               $90,000                    $200,000

Salvage value now                                                              $42,000

Investment in major overhaul

needed in next year                        $55,000

Salvage value in 8 years                 $15,000                      $90,000

Remaining life                                   8 years                         8 years

Net cash flow per year                   $30,425                       $43,900

initial investment                            -$55,000                    -$158,000

cash flow years 1-7                          $30,425                       $43,900

cash flow year 8                              $45,425                      $133,900

discount rate                                          7%                               7%

I used an excel spreadsheet to calculate the following

net present value                           $135,407                       $156,521

IRR                                                        54%                             26%

payback period                              1.81 years                     3.6 years

profitability index                               3.46                            1.99

(= PV of cash flows / investment)

in terms of experimental research, mcdonald’s charging different prices in the two cities relates to

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