Basics of Capital Investment Kenn Day, manager of Day Laboratory, is investigating the possibility of acquiring some new test equipment. The equipment requires an initial outlay of $300,000. To raise the capital, Kenn will sell stock valued at $200,000 (the stock pays dividends of $24,000 per year)

Question

Basics of Capital Investment Kenn Day, manager of Day Laboratory, is investigating the possibility of acquiring some new test equipment. The equipment requires an initial outlay of $300,000. To raise the capital, Kenn will sell stock valued at $200,000 (the stock pays dividends of $24,000 per year) and borrow $100,000. The loan for $100,000 would carry an interest rate of 6%. Kenn figures that his weighted average cost of capital is 10% [(2/3 × 0.12) + (1/3 × 0.06)]. This weighted cost of capital is the discount rate that will be used for capital investment decisions.

Kenn estimates that the new test equipment will produce a cash inflow of $50,000 per year.

Kenn expects the equipment to last for 20 years.

Required:

1. Compute the payback period.
2. Assuming that depreciation is $14,000 per year, compute the ARR (on total investment).
3. Compute the NPV of the test equipment.
4. Compute the IRR of the test equipment.
5. Should Kenn buy the equipment?

Accepted Answer

1. The payback period is $300,000/$50,000, or 6 years.

2. The ARR is ($50,000 − $14,000)/$300,000, or 12%.

3. From Exhibit 12B.2 (p. 671), the discount factor for an annuity with i at 10% and n at 20 years is 8.51356. Thus, the NPV is (8.51356 × $50,000) − $300,000, or $125,678.

4. The discount factor associated with the IRR is 6.00000 ($300,000/$50,000). From Exhibit 12B.2, the IRR is between 14 and 16% (using the row corresponding to Period 20).

5. Since the NPV is positive and the IRR is greater than Kenn’s cost of capital, the test equipment is a sound investment. This, of course, assumes that the cash flow projections are accurate.

Question 12.RP.1: Basics of Capital Investment Kenn Day, manager of Day Labora...

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