Almendarez Corporation is considering the purchase of a machine that would cost 130,000andwouldlastfor6years.Attheendof6years,themachinewouldhaveasalvagevalueof18,000. By reducing labor and other operating costs, the machine would provide annual cost savings of $44,000. The company requires a minimum pretax return of 19% on all investment projects. (Ignore income taxes.)
The Correct Answer and Explanation is:
To determine whether Almendarez Corporation should purchase the machine, we need to evaluate the investment using the payback period and net present value (NPV) approach, particularly focusing on the NPV since the company requires a minimum pretax return of 19 percent.
Given:
- Initial cost of the machine: $18,000
- Annual cost savings (benefit): $44,000
- Required rate of return: 19 percent
- Income taxes: Ignored
- Time horizon: Not specified, assume the machine lasts indefinitely or until payback
Since the machine costs $18,000 and provides annual savings of $44,000, the payback period is:Payback Period=18,00044,000≈0.41 years\text{Payback Period} = \frac{18,000}{44,000} \approx 0.41 \text{ years}Payback Period=44,00018,000≈0.41 years
This is less than one year, which already suggests the investment is quickly recovered.
Now, calculate the Net Present Value using the formula for a perpetuity, since no specific life span was mentioned:NPV=Annual Cash Savingsr−Initial Investment\text{NPV} = \frac{\text{Annual Cash Savings}}{r} – \text{Initial Investment}NPV=rAnnual Cash Savings−Initial InvestmentNPV=44,0000.19−18,000=231,578.95−18,000=213,578.95\text{NPV} = \frac{44,000}{0.19} – 18,000 = 231,578.95 – 18,000 = 213,578.95NPV=0.1944,000−18,000=231,578.95−18,000=213,578.95
Conclusion:
The Net Present Value is positive at $213,578.95, which means the investment will generate significantly more in savings than its cost when evaluated at the required rate of return. A positive NPV indicates that the project will increase the value of the company and meet its required return criteria. Furthermore, the short payback period of less than half a year reduces risk and improves liquidity.
Therefore, Almendarez Corporation should proceed with the purchase of the machine, as it is a financially sound investment.
