Chapter 26, Problem P26.36BPGB

Using payback, ARR, and NPV with unequal cash flows

Gaynor Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of $ 1,600,000. If refurbished, Gaynor expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of $3,800,000. A new machine would last 10 years and have no residual value. Gaynor expects the following net cash inflows from the two options.

Year	Refurbish Current Machine	Purchase New Machine
1	$ 400,000	5 2,700,000
2	370,000	450,000
3	320,000	400,000
4	270.000	350,000
5	220,000	300,000
6	220,000	300,000
7	220,000	300,000
8	220,000	300,000
9		300,000
10		300,000
Total	$ 2,240.000	$ 5,700,000

Gaynor uses straight-line depreciation and requires an annual return of 10%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.
2. Which option should Gaynor choose? Why?