Case Study:

A manufacturing company is evaluating two options for new equipment to introduce a new product to its suite of goods. The details for each option are provided below:

Option 1

• $65,000 for equipment with useful life of 7 years and no salvage value.
• Maintenance costs are expected to be $2,700 per year and increase by 3% in Year 6 and remain at that rate.
• Materials in Year 1 are estimated to be $15,000 but remain constant at $10,000 per year for the remaining years.
• Labor is estimated to start at $70,000 in Year 1, increasing by 3% each year after.

Revenues are estimated to be:

Year 1Year 2Year 3Year 4Year 5Year 6Year 7-75,000100,000125,000150,000150,000150,000

Option 2

• $85,000 for equipment with useful life of 7 years and a $13,000 salvage value
• Maintenance costs are expected to be $3,500 per year and increase by 3% in Year 6 and remain at that rate.
• Materials in Year 1 are estimated to be $20,000 but remain constant at $15,000 per year for the remaining years.
• Labor is estimated to start at $60,000 in Year 1, increasing by 3% each year after.

Revenues are estimated to be:

Year 1Year 2Year 3Year 4Year 5Year 6Year 7-80,00095,000130,000140,000150,000160,000

The company's required rate of return and cost of capital is 8%.

Management has turned to its finance and accounting department to perform analyses and make a recommendation on which option to choose. They have requested that the three main capital budgeting calculations be done: NPV, IRR, and Payback Period for each option.

For this assignment, compute all required amounts and explain how the computations were performed. Evaluate the results for each option and explain what the results mean. Based on your analysis, recommend which option the company should pursue.