Wendell’s Donut Shoppe is investigating the purchase of a new $48,300 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of $6,800 per year.

Wendell’s Donut Shoppe is investigating the purchase of a new $48,300 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of $6,800 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 1,700 dozen more donuts each year. The company realizes a contribution margin of $2.00 per dozen donuts sold. The new machine would have a six-year useful life.

Required:

1. What would be the total annual cash inflows associated with the new machine for capital budgeting purposes?

2. What discount factor should be used to compute the new machine’s internal rate of return? (Round your answers to 3 decimal places.)

3. What is the new machine’s internal rate of return? (Round your final answer to nearest whole percentage.)

4. In addition to the data given previously, assume that the machine will have a $15,685 salvage value at the end of six years. Under these conditions, what is the internal rate of return? (Hint: You may find it helpful to use the net present value approach; find the discount rate that will cause the net present value to be closest to zero.) (Round your final answer to nearest whole percentage.)

Explanation

1.

Annual savings in part-time help	$	6,800
Added contribution margin from expanded sales (1,700 dozen × $2.00 per dozen)		3,400
Annual cash inflows	$	10,200

2.

Factor of the internal rate of return	=	investment required
		Annual cash inflow
	=	$48,300	= 4.735
		$10,200

3.

Looking in Exhibit 13B-2, and scanning along the six-period line, we can see that the factor computed above, 4.735, is closest to 4.767, the factor for the 7% rate of return. Therefore, to the nearest whole percent, the internal rate of return is 7%.

4.

The cash flows will not be even over the six-year life of the machine because of the extra $15,685 inflow in the sixth year. Therefore, the above approach cannot be used to compute the internal rate of return in this situation. Using trial-and-error or some other method, the internal rate of is 13%:

	Now			Years 1-6		Year 6
Purchase of machine	$	(48,300	)
Reduced part-time help				$	6,800
Added contribution margin					3,400
Salvage value of machine						$	15,685
Total cash flows (a)		(48,300	)	$	10,200	$	15,685
Discount factor (13%) (b)		1.000			3.998		0.480
Present value (a) × (b)	$	(48,300	)	$	40,780	$	7,529
Net present value	$	0

Thanks