Accounting

Capital Investment Case

Waterways Corporation is a private company providing irrigation and drainage products and services for residential, commercial, and public sector projects, including farms, parks, and sports fields. It has a plant located in a small city north of Toronto that manufactures the products it markets to retail outlets across Canada. It also maintains a division that provides installation and warranty servicing in the Greater Toronto Area. The mission of Waterways is to manufacture quality parts that can be used for effective water management, be it drainage or irrigation. The company hopes to satisfy its customers with its products, provide rapid and responsible service, and serve the community and the employees who represent it in each community. Waterways puts much emphasis on cash flow when it plans for capital investments. The company chose its discount rate of 8% based on the rate of return it must pay its owners and creditors. Using that rate, Waterways then uses different methods to determine the best decisions for making capital outlays. In 2020 Waterways is considering buying five new backhoes to replace the backhoes it now has at its installation and training division. The new backhoes are faster, cost less to run, provide for more accurate trench digging, have comfort features for the operators, and have associated one-year maintenance agreements. The old backhoes are working well, but they do require considerable maintenance. The operators are very familiar with the old backhoes and would need to learn some new skills to use the new equipment. The following information is available to use in deciding whether to purchase the new backhoes.

Old Backhoes New Backhoes

Purchase cost when new $90,000 $200,000

Salvage value now $42,000 None

Investment in major overhaul needed in next year $55,000 None

Salvage value in 8 years None $ 50,000

Remaining life 8 years 8 years

Net cash flow generated each year $25,250 $ 41,000

Instructions

a. Using the following methods, evaluate whether to purchase the new equipment or overhaul the old equipment. (Hint: For the old machine, the initial investment is the cost of the overhaul. For the new machine, subtract the salvage value of the old machine to determine the initial cost of the investment.) Ignore income taxes in your analysis.

1. Use the net present value method for buying new or keeping the old. 2. Use the payback method for each choice. (Hint: For the old machine, evaluate the payback of an overhaul.) 3. Compare the profitability index for each choice. 4. Compare the internal rate of return for each choice to the required 8% discount rate.

b. Are there any intangible benefits or negatives that would influence this decision? c. What decision would you make and why?