Johnny James is the manager of North Division, a division of Global Company. Johnny is considering updating North’s production process with a $10 million investment in new production machinery. The new equipment would have a useful life of 12 years and zero salvage value. Global has a weighted average cost of capital rate of 8%. The new equipment would reduce annual cash operating costs by $1.8 million per year.
Required:
a. What is the investment’s net present value? Should the equipment be purchased?
b. What is the payback period, in years, for this equipment? If Global Company has a rule that requires only capital projects with payback periods of less than 7 years to be initiated, should this equipment be purchased?
c. What is this project’s internal rate of return? Should this project be purchased?
d. Assume that Global uses the straight-line method to compute depreciation expense. Compute the Accounting Rate of Return (Simple Rate of Return) for this equipment purchase. Why is this value different from the internal rate of return computed in part c?