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18 February, 11:40

Red Sox Corporation wants to purchase a new machine for $350,000. Management predicts that the machine can produce sales of $205,000 each year for the next 5 years. Expenses are expected to include direct materials, direct labor, and factory overhead (excluding depreciation) totaling $85,000 per year. The firm uses straight-line depreciation with no residual value for all depreciable assets. Pique's combined income tax rate is 35%. Management requires a minimum after-tax rate of return of 10% on all investments. What is the payback period for the new machine (rounded to nearest one-tenth of a year) ? (Assume that the cash inflows occur evenly throughout the year.)

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  1. 18 February, 11:52
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    The payback period for the new machine is 3.5 years.

    Explanation:

    Pay Back Period: The pay back period shows that period in which the borrower has to repay the borrowed amount taken by the financial institution.

    In Mathematically,

    Payback Period = Initial Investment : Annual cash inflows

    where initials investment is $350,000 given

    And, the annual cash flows is to computed which is shown below:

    = Sales - all expenses - Depreciation - tax rate + depreciation

    where,

    Sales - all expenses - Depreciation = Net income before tax

    Net income before tax - tax rate = Net income after tax

    Net income after tax + depreciation = Annual cash inflows

    And Depreciation = (Purchase cost - Residual value) : Useful life

    So,

    Depreciation = $350,000 : 5 = $ 70,000

    $205,000 - $85,000 - $70,000 = Net income before tax = $50,000

    $40,000 - 35% = Net income after tax = $32,500

    $32500 + $ 70,000 = Annual cash inflows = $102,500

    Since the depreciation is non cash expense, so it is added back.

    Now Payback period = Initial Investment : Annual cash inflows

    = $350,000 : $102,500

    = 3.5 years.

    Thus, the payback period for the new machine is 3.5 years.
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