BSU Inc. wants to purchase a new machine for $45,600, excluding $1,200 of installation costs. The old machine was bought five years ago and had an expected economic life of 10 years without salvage value. This old machine now has a book value of $1,900, and BSU Inc. expects to sell it for that amount. The new machine would decrease operating costs by $10,000 each year of its economic life. The straight-line depreciation method would be used for the new machine, for a six-year period with no salvage value. a. Determine the cash payback period.
b. Determine the approximate internal rate of return.
c. Assuming the company has a required rate of return of 7%, determine whether the new machine should be purchased.

4.49 years

IRR = 8.97% or 9% approximately

The machine should be purchased because the IRR is greater than the required return

Explanation:

Net investment cost = Cost of new machine - salvage value of old machine + tax (salvage value of old machine - book value of old machine)

cost of the new machine = cost of the machine + installation cost

$45,600 + $1,200 = $46800

Net investment cost =  $46800 - $1,900 + 0 = $44,900

Payback calculates the amount of time it takes to recover the amount invested in a project from it cumulative cash flows

Payback period = Amount invested / cash flow

44,900 / 10,000 = 4.49 years

Internal rate of return is the discount rate that equates the after-tax cash flows from an investment to the amount invested

IRR can be calculated with a financial calculator  

Cash flow in year 0 = -44,900

Cash flow each year from year 1 to 6 = $10,000

IRR = 8.97% or 9% approximately

The machine should be purchased because the IRR is greater than the required return

To find the IRR using a financial calculator:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. After inputting all the cash flows, press the IRR button and then press the compute button.  

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