Wizard Company has an old machine that is fully depreciated but has a current salvage value of $10,000. The company wants to purchase a new machine that would cost $60,000 and have a five-year useful life and zero salvage value. Expected changes in annual revenues and expenses if the new machine is purchased are:
| Increased revenues | $120,000 | |
| Increased expenses | ||
| Salary of additional operator | $56,000 | |
| Supplies | 14,000 | |
| Depreciation | 12,000 | |
| Maintenance | 8,000 | 90,000 |
| Increased net income | $30,000 |
(Ignore income taxes in this problem.)
1. What is the payback period on the new equipment?
2. What is the simple rate of return on the new equipment?
Wizard Company is facing a decision regarding the purchase of a new machine to replace an old, fully depreciated one with a current salvage value of $10,000. This decision hinges on various financial factors, such as the payback period and simple rate of return. In this essay, we will analyze these metrics to assess the financial feasibility of investing in the new equipment.
The payback period is a crucial financial metric that helps businesses determine how long it will take to recoup their initial investment. In the case of Wizard Company, the new machine costs $60,000. To calculate the payback period, we need to assess how long it will take for the increased net income of $30,000 to recover the initial investment.
Payback Period = Initial Investment / Annual Cash Inflow
In this scenario: Initial Investment = $60,000 Annual Cash Inflow = Increased Net Income = $30,000
Payback Period = $60,000 / $30,000 = 2 years
Thus, Wizard Company can expect to recover its investment in the new equipment within 2 years. This relatively short payback period suggests that the investment is financially attractive.
The simple rate of return, also known as the accounting rate of return, provides insights into the profitability of an investment. It is calculated by dividing the average annual accounting profit by the initial investment. In this case, the average annual accounting profit is the increased net income of $30,000.
Simple Rate of Return = Average Annual Accounting Profit / Initial Investment
In this scenario: Average Annual Accounting Profit = $30,000 Initial Investment = $60,000
Simple Rate of Return = $30,000 / $60,000 = 0.5 or 50%
The simple rate of return on the new equipment is 50%.
The analysis of Wizard Company’s decision to purchase the new machine reveals that the investment is financially sound. With a payback period of only 2 years and a simple rate of return of 50%, the company can expect to recoup its initial investment quickly and enjoy a substantial return on the investment over its five-year useful life. It’s important to note that this analysis ignores income taxes, so Wizard Company should consider tax implications as part of its overall decision-making process. Nonetheless, based solely on these financial metrics, acquiring the new equipment appears to be a wise choice for the company’s growth and profitability.
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