Valeria Products is considering the purchase of a new machine costing $500 000.The machine is expected to reduce annual operating costs by $90 000 and will be depreciated using the straight-line method (with no half-year convention)over 10 years with no salvage value at the end of its useful life.Assuming a 40 per cent income tax rate,the machine's payback period is:

Question

Quizplus · Accepted Answer

The payback period can be calculated by dividing the initial investment by the annual cash inflows. In this case, the initial investment is $500,000 and the annual cash inflows are the annual operating cost savings of $90,000.

Payback period = $500,000 ÷ $90,000 = 5.56

However, we need to take into account the effect of taxes on the cash inflows. The after-tax cash inflows are calculated as:

After-tax cash inflows = (Operating cost savings - Depreciation) x (1 - Tax rate)

= ($90,000 - $50,000) x (1 - 0.4)

= $24,000

where the depreciation expense per year is calculated as $500,000 ÷ 10 = $50,000.

Using the after-tax cash inflows, the payback period is:

Payback period = $500,000 ÷ $24,000 = 20.83 years

Therefore, the payback period for the machine is longer than the company's target payback period, so the machine should not be purchased. The best choice is not to purchase the machine.

Valeria Products Is Considering the Purchase of a New Machine