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Payback Period, IRR

The management of Kitchen Shop is thinking of buying a new drill press to aid in adapting parts for different machines. The press is expected to save Kitchen Shop $8,000 per year in costs. However, Kitchen Shop has an old punch machine that isn't worth anything on the market and that will probably last indefinitely. The new press will last 12 years and will cost $41,595. (Ignore income tax effects.)

1. Compute the payback period of the new machine.
2. Compute the internal rate of return.
3. Interpretive Question: What uncertainties are involved in this decision? Discuss how they might be dealt with.

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Solution Preview

Please see the attached file.

1. Payback period is the period in which the cash outflows are recovered

in $
Cash Outflow 41595

Cash inflow 8000 per annum for 12 years
(Here cash inflows are in nature of annuity as they are getting equal inflows per annum)

Pay back period=Cash outflow/Annuity =5.20 years

2. IRR is the return at which the present value of cash inflows are equal to the initial outlay.

Year0 -41595
Year1 8000
Year2 8000
Year3 8000
Year4 8000
Year5 8000
Year6 8000
Year7 8000
Year8 8000
Year9 ...

Solution Summary

The payback period is explained and the internal rate of return is computed.