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 andcreditors. Using that rate,Waterways then uses different methods to determine the best decisionsfor making capital outlays.In 2009 Waterways is considering buying five new backhoes to replace the backhoes it nowhas. 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 withthem.The old backhoes are working just fine, but they do require considerable maintenance.Thebackhoe operators are very familiar with the old backhoes and would need to learn some newskills to use the new backhoes.The following information is available to use in deciding whether to purchase the newbackhoes.Old Backhoes New BackhoesPurchase cost when new $90,000 $200,000Salvage value now $42,000Investment in major overhaul needed in next year $55,000Salvage value in 8 years $15,000 $90,000Remaining life 8 years 8 yearsNet cash flow generated each year $40,425 $53,900(a) Evaluate in the following ways whether to purchase the new equipment or overhaul the oldequipment. (Hint: For the old machine, the initial investment is the cost of the overhaul. Forthe new machine, subtract the salvage value of the old machine to determine the initial costof 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 paybackof 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?
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