Waterways puts much emphasis on cash flow when it plans for capital investments.
The company chose its discount rate of 8% based on the rate of return it must pay its owners and
creditors. Using that rate,Waterways then uses different methods to determine the best decisions
for making capital outlays.
In 2009 Waterways is considering buying five new backhoes to replace the backhoes it now
has. The new backhoes are faster, cost less to run, provide for more accurate trench digging,
have comfort features for the operators, and have 1-year maintenance agreements to go with
them.The old backhoes are working just fine, but they do require considerable maintenance.The
backhoe operators are very familiar with the old backhoes and would need to learn some new
skills to use the new backhoes.
The following information is available to use in deciding whether to purchase the new
Old Backhoes New Backhoes
Purchase cost when new $90,000 $200,000
Salvage value now $42,000
Investment in major overhaul needed in next year $55,000
Salvage value in 8 years $15,000 $90,000
Remaining life 8 years 8 years
Net cash flow generated each year $40,425 $53,900
(a) Evaluate in the following ways whether to purchase the new equipment or overhaul the old
equipment. (Hint: For the old machine, the initial investment is the cost of the overhaul. For
the new machine, subtract the salvage value of the old machine to determine the initial cost
of the investment.)
(1) Using the net present value method for buying new or keeping the old.
(2) Using the payback method for each choice. (Hint: For the old machine, evaluate the payback
of an overhaul.)
(3) Comparing the profitability index for each choice.
(4) Comparing the internal rate of return for each choice to the required 8% discount rate.
(b) Are there any intangible benefits or negatives that would influence this decision?
(c) What decision would you make and why?