Waterways puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 7% 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. This year 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 backhoes.

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 $30,425 $43,900

Instructions

(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?

buying the new backhoes has a higher net present value (NPV), so we should choose that project according to this method of evaluation ($156,521 > $135,407 )

(2) Using the payback method for each choice.

the payback period for keeping the old backhoes is shorter than buying new backhoes, so we should choose that project according to this method of evaluation (1.81 years < 3.6 years)

(3) Comparing the profitability index for each choice.

keeping the old backhoes also has a higher profitability index, so we should choose that project according to this method of evaluation (3.46 > 1.99)

(4) Comparing the internal rate of return for each choice to the required 7% discount rate.

Both project have a very high IRR, but keeping the old backhoes has a higher IRR, so we should choose that project according to this method of evaluation (54% > 26%)

(b) Are there any intangible benefits or negatives that would influence this decision?

The new backhoes provide intangible benefits that the old backhoes do not, e.g. they are faster and more accurate which results in better work done. While the old backhoes require a lot of maintenance work and once starts to require a lot of maintenance, the odds are that they will keep breaking even more than expected.

(c) What decision would you make and why?

I would purchase the new backhoes because it would improve the company's work and efficiency, since old equipment tends to break a lot specially construction equipment. Even though the NPV is the only method of valuation where the new backhoes were better, it is also the most important one.

Explanation:

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 per year $30,425 $43,900

initial investment -$55,000 -$158,000

cash flow years 1-7 $30,425 $43,900

cash flow year 8 $45,425 $133,900

discount rate 7% 7%

I used an excel spreadsheet to calculate the following

net present value $135,407 $156,521

IRR 54% 26%

payback period 1.81 years 3.6 years

profitability index 3.46 1.99

(= PV of cash flows / investment)