After an extensive feasibility study on savings strategies thatcost $25,000, Bright Ltd is considering the purchase of newequipment costing $500,000, which it will fully finance with afixed interest loan of 10% per annum, with the principal repaid atthe end of 4 years.

The new equipment will reduce the company’s manufacturing costsby $190,000 a year for 4 years. Bright will depreciate theequipment by the straight-line method to zero salvage value overthe 4 years. The company thinks that it can sell the equipment atthe end of 4 years for $20,000.

Bright will install the equipment in a building which iscurrently being rented out for $30,000 a year under a leaseagreement with 4 yearly rental payments to run, the next one beingdue at the end of one year. Under the lease agreement, Bright Ltdcan cancel the lease by paying the tenant today compensation equalto one year’s rental payment plus 10%, but this amount is notdeductible for income tax purposes.

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The company further estimates that it will have to spend $15,000in 2 years’ time overhauling the equipment. It will also requireadditions to current assets of $35,000 at the beginning of theproject, which will be fully recoverable at the end of the fourthyear.

Bright Ltd’s cost of capital is 12%. The tax rate is 30%. Tax ispaid in the year in which earnings are received.

1. Calculate the incremental cash flows.                                                   
2. Calculate the payback period of the proposed purchase.                      
3. Calculate the net present value, that is, the net benefit ornet loss in present value terms of the proposed purchase.                                                   
4. Calculate the present value index of the proposed purchase.                  
5. Should the company purchase the equipment? Explain why or whynot.