A3Q1 Choo Choo Inc. is a manufacturer of model trains. The company is considerin
ID: 2807474 • Letter: A
Question
A3Q1
Choo Choo Inc. is a manufacturer of model trains. The company is considering the purchase of an industrial 3D printer, which will allow the firm to produce custom-made model trains for its high-end customers. The printer will cost $1,000,000, and it is expected to produce net cash flows of $350,000 per year for the next six years. Liquidation of the equipment will net the firm $100,000 in cash at the end of six years. The firm requires a 13% rate of return on all investments. Ignore the effects of taxes.
a. What is the payback period for the proposed investment in the 3D printer? Provide your answer in number of years and months.
b. What is the printer’s discounted payback period? Provide your answer in number of years and months.
c. Choo Choo’s cutoff period is set at three years. Based on the payback period investment criterion, will the company purchase the printer? Will it purchase the printer based on the discounted payback period investment criterion?
d. What is the printer’s net present value (NPV)? Should the company purchase the printer based on the NPV investment criterion?
e. What is the printer’s profitability index (PI)? Should the company purchase the printer based on the PI investment criterion?
f. What is the printer’s internal rate of return (IRR)?
g. Check that at the internal rate of return (IRR) the net present value of the printer is $0. Should the company purchase the printer based on the IRR investment criterion?
h. Based on your answers in parts a-f above, what decision do you recommend for Choo Choo?
Explanation / Answer
a-
cost of machine
1000000
annual cash flow
350000
payback period in years
initial investment/annual cash flow
2.857143
b-
year
cash flow
present value of cash flow = cash flow/(1+r)^n r = 13%
1
350000
309734.5
309734.5
2
350000
274101.3
583835.9
3
350000
242567.6
826403.4
4
350000
214661.6
173596.6
5
350000
189966
6
350000
168111.5
100000
48031.85
discounted pay back period
previous year+(amount to be recovered in final year/ discounted cash flow of year)
3+(173596.6/214661.6)
3.808699
c-
select the project as payback period is less than 3 years while reject as per discounted pay back period. It is more than 3 years
d-
year
cash flow
present value of cash flow = cash flow/(1+r)^n r = 13%
1
350000
309734.5
2
350000
274101.3
3
350000
242567.6
4
350000
214661.6
5
350000
189966
6
350000
168111.5
6
100000
48031.85
sum of present value of cash flow
1447174
less cash outflow
1000000
net present value
e-
profitability index
sum of present value of cash flow/cash outflow
1.447174
f-
year
cash flow
0
-1000000
1
350000
2
350000
3
350000
4
350000
5
350000
6
450000
IRR = USING IRR FUNCTION IN M S EXCEL SPREADSHEET =IRR(-1000000,350000,350000,350000,350000,350000,450000)
27.4887%
G-
year
cash flow
present value of cash flow = cash flow/(1+r)^n r = 27.4887%
0
-1000000
-1000000
1
350000
274534.1
2
350000
215340
3
350000
168909.1
4
350000
132489.4
5
350000
103922.5
6
450000
104805.1
NPV
SUM OF PRESENT VALUE OF CASH FLOW
0.206394
YES MACHINE SHOULD BE PURCHASED AT IRR OF 27.4887%
H
payback period in years
Accept
discounted pay back period
reject
NPV
Accept
PI
Accept
IRR
Accept
a-
cost of machine
1000000
annual cash flow
350000
payback period in years
initial investment/annual cash flow
2.857143
b-
year
cash flow
present value of cash flow = cash flow/(1+r)^n r = 13%
1
350000
309734.5
309734.5
2
350000
274101.3
583835.9
3
350000
242567.6
826403.4
4
350000
214661.6
173596.6
5
350000
189966
6
350000
168111.5
100000
48031.85
discounted pay back period
previous year+(amount to be recovered in final year/ discounted cash flow of year)
3+(173596.6/214661.6)
3.808699
c-
select the project as payback period is less than 3 years while reject as per discounted pay back period. It is more than 3 years
d-
year
cash flow
present value of cash flow = cash flow/(1+r)^n r = 13%
1
350000
309734.5
2
350000
274101.3
3
350000
242567.6
4
350000
214661.6
5
350000
189966
6
350000
168111.5
6
100000
48031.85
sum of present value of cash flow
1447174
less cash outflow
1000000
net present value
e-
profitability index
sum of present value of cash flow/cash outflow
1.447174
f-
year
cash flow
0
-1000000
1
350000
2
350000
3
350000
4
350000
5
350000
6
450000
IRR = USING IRR FUNCTION IN M S EXCEL SPREADSHEET =IRR(-1000000,350000,350000,350000,350000,350000,450000)
27.4887%
G-
year
cash flow
present value of cash flow = cash flow/(1+r)^n r = 27.4887%
0
-1000000
-1000000
1
350000
274534.1
2
350000
215340
3
350000
168909.1
4
350000
132489.4
5
350000
103922.5
6
450000
104805.1
NPV
SUM OF PRESENT VALUE OF CASH FLOW
0.206394
YES MACHINE SHOULD BE PURCHASED AT IRR OF 27.4887%
H
payback period in years
Accept
discounted pay back period
reject
NPV
Accept
PI
Accept
IRR
Accept