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Managerial Accounting: The Corners...

7th Edition
Maryanne M. Mowen + 2 others
ISBN: 9781337115773
BuyFindarrow_forward

Managerial Accounting: The Corners...

7th Edition
Maryanne M. Mowen + 2 others
ISBN: 9781337115773
Textbook Problem
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Foster Company wants to buy a numerically controlled (NC) machine to be used in producing specially machined parts for manufacturers of trenching machines (to replace an existing manual system). The outlay required is $3,500,000. The NC equipment will last 5 years with no expected salvage value. The expected incremental after-tax cash flows (cash flows of the NC equipment minus cash flows of the old equipment) associated with the project follow:

Chapter 12, Problem 48P, Foster Company wants to buy a numerically controlled (NC) machine to be used in producing specially

Foster has a cost of capital equal to 10%. The above cash flows are expressed without any consideration of inflation.

Required:

  1. 1. Compute the payback period.
  2. 2. Calculate the NPV and IRR of the proposed project.
  3. 3. CONCEPTUAL CONNECTION Inflation is expected to be 5% per year for the next 5 years. The discount rate of 10% is composed of two elements: the real rate and the inflationary element. Since the discount rate has an inflationary component, the projected cash flows should also be adjusted to account for inflation. Make this adjustment, and recalculate the NPV. Comment on the importance of adjusting cash flows for inflationary effects.

1.

To determine

Calculate the payback period.

Explanation

Payback Period:

The time taken by an investment to recover its original value is known as payback period. It is calculated by dividing the original amount of investment by annual cash flow from the investment.

Use the following formula to calculate payback period:

Pyabackperiod=InvestmentAnnualcashflow

Substitute $3,500,000 for investment and $900,0001 for annual cash flow in the above formula.

Pyabackperiod=$3,500,000$900,000=3

2.

To determine

Find out NPV and IRR of the proposed project.

3.

To determine

Find out the NPV by taking inflation into consideration. Also, discuss the importance of adjustments in cash flow for inflationary effects.

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