11 You are a consultant in a meeting with the owner and the

11) You are a consultant in a meeting with the owner and the controller of a company. The company is ready to go \"to the next level\", and to do so needs to purchase a Makino T-4 five axis CNC milling machine for $750,000. The sales manager estimates that with this new machine, they can generate the following cash flows:

**PLEASE SHOW WORK**

YEAR ONE: 125,000

YEAR TWO: 175,000

YEAR THREE: 225,000

YEAR FOUR: 235,000

YEAR FIVE: 235,000

The owner wants to make sure that the machine pays for itself in 5 years and the controller tells him to use the payback method. a) In what year does the machine pay for itself using the payback method.

a) In what year does the machine pay for itself using the payback method?

b) As the consultant, you advise that they determine the net present value and decide to target 15% as your required return. What is the NPV for this project?

c) Do you do the deal?

d) What is the IRR?

Solution

Part A)

Payback period is the period within which the initial investment is recovered by the company with the use of cash flows. The payback period is calculated as follows:

As it can be seen from the above table (cumulative cash flow column), that the initial investment of $750,000 will get recovered between Year 3 and Year 4. The formula for calculating payback period is given below:

Payback Period = Years upto which Partial Recovery is Made + Balance/Cash Flow of the Year in which Full Recovery is Made

Payback Period = 3 + (750,000 - 525,000)/235,000 = 3.96 Years

The machine pays for itself in 3.96 Years

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Part B)

NPV is the difference between the present value of cash inflows and cash outflows. The formula for calculating NPV is given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Required Return)^1 + Cash Flow Year 2/(1+Required Return)^2 + Cash Flow Year 3/(1+Required Return)^3 + Cash Flow Year 4/(1+Required Return)^4 + Cash Flow Year 5/(1+Required Return)^5

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Using the values provided in the question, we get,

NPV = -750,000 + 125,000/(1+15%)^1 + 175,000/(1+15%)^2 + 225,000/(1+15%)^3 + 235,000/(1+15%)^4 + 235,000/(1+15%)^5 = -$109,839.51

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Part C)

No, the deal shouldn\'t be done. It is so because the NPV of the machine is negative. Even though the payback method indicates recovery within the estimated period of 5 years, it cannot be considered as a reliable measure for making investment decisions.

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Part D)

IRR is the minimum acceptable rate of return from a project IRR can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic formula for calculating IRR is given below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5

IRR has been calculated with the use of EXCEL as follows:

IRR = 9.23%