Question

A piece of laborsaving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow:
Purchase cost of the equipment $ 484,500

Annual cost savings that will be

provided by the equipment $ 85,000

Life of the equipment 12 years



Required:

1-a. Compute the payback period for the equipment.



1-b.

If the company requires a payback period of four years or less, would the equipment be purchased?


Yes

No



2-a.

Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment’s useful life.




2-b. Would the equipment be purchased if the company’s required rate of return is 14%?

Answer 1

Answer:

1a. Payback period = Initial outlay

                                  Annual cost saving

                                = $484,500

                                    $85,000

                                 = 5.7 years

b. The equipment should not be purchased because it has a longer payback period than the company's required payback period.

2a.                                      $

Annual cost saving         85,000

Less: Depreciation          40,375

Annual profit                    44,625

Simple rate of return = Annual profit  x 100

                                      Initial outlay

                                      $44,625    x 100

                                      $484,500

                                    = 9.21%

Depreciation = Cost - Residual value

                         estimated useful life

                      = $484,500 - 0

                               12 years

                      = $40,375 per annum

2b, The equipment should not be purchased because the simple rate of return is lower than the company's required rate of return.

Explanation:

Payback period is the ratio of initial outlay to annual cost saving. It is the period in which the initial outlay is recouped.

Simple rate of return is the ratio of annual profit to initial outlay. It measures the rate of return on capital invested.