BioChem plans to replace an old piece of research equipment which is obsolete and becoming increasingly unreliable under the stress of daily operations. The equipment is fully depreciated, and no salvage value can be realised upon its disposal.
One piece of replacement equipment under consideration would provide annual cash savings of $84 000 before income taxes. The equipment would cost $216 000 and have an estimated useful life of five years. The equipment is expected to have no salvage value at the end of five years.
BioChem uses the straight-line depreciation method for all equipment for both accounting and tax purposes. The company is subject to a 40 percent tax rate. The company has an after-tax required rate of return of 12 percent.
1. Calculate, for BioChem’s proposed investment in new equipment, the after-tax: (a) Payback period.
(b) Accounting rate of return.
(c) Net present value.
(d) Profitability index.
(e) Internal rate of return.
Assume that all operating revenues and expenses occur at the end of the year.
2. Identify and discuss the issues that BioChem management should consider when deciding which of the five techniques identified in requirement 1 should be employed to evaluate alternative capital investment projects.