Net Present Value/Present Value Index
The management team at Savage Corporation is evaluating two alternative capital investment opportunities. The first alternative, modernizing the company’s current machinery, costs $45,000. Management estimates the modernization project will reduce annual net cash outflows by $12,500 per year for the next five years. The second alternative, purchasing a new machine, costs $56,500. The new machine is expected to have a five-year useful life and a $4,000 salvage value. Management estimates the new machine will generate cash inflows of $15,000 per year. Savage’s cost of capital is 10%.
a. Determine the present value of the cash flow savings expected from the modernization program. Using the data from Appendix on page 1169 of our text 15000*3.790787 = 47,385, which should be the PV cash flow savings expected from the first option of modernization program. b. Determine the net present value of the modernization project. I believe the NPV of the 1st project is calculated by subtracting current machinery, costs $45,000 from the figure above which equals 2,385.00 c. Determine the net present value of investing in the new machine. This is determined by valuing the future cash flows. Using the same appendix in table 2 data, annual cash flow of 15,000 * 3.790787 =56862.00
Salvage cost of 4,000 * .620921 (table 3 on page 523) = 2484.00
Total=59,346.00 less the cost of machinery 56,500 = 2486.00 as the NPV d. Use a present value index to determine which investment alternative will yield the higher rate of return. PI= $15,000*.620921/56,500 = .16
This investment is not acceptable because it has a PI of less than 1.0 therefore the modernization project or the first alternative will have higher rate of return.
Exercise 24-4A Determining the present value of an annuity
The dean of the School of Social Science is trying to decide whether to purchase a copy machine to place in the lobby of the building. The machine would add to student convenience, but the dean feels compelled to earn an 8 percent return on the investment of funds. Estimates of cash inflows from copy machines that have been placed in other university buildings indicate that the copy machine would probably produce incremental cash inflows of approximately $8,000 per year. The machine is expected to have a three-year useful life with a zero salvage value.
a. Use Present Value Table 1 in Appendix A to determine the maximum amount of cash the dean should be willing to pay for a copy machine.
Years 1 – 3; where N = 1 r at 8%, N =2, r@ 8%, N = 3 r @ 8% 8000*.925926 = 7,407.41
8000*.857339 = 6,858.71
8000*.793832 = 6,350.66
Present Value / Ordinary Annuity = ($) 20,617.00
Present Value / Annuity-Due = ($) 22,266
b. Use Present Value Table 2 in Appendix A to determine the maximum amount of cash the dean should be willing to pay for a copy machine. Based on table 2 in appendix a, the maximum amount of cash the Dean should be willing to pay for a copy machine is ($) 20,617.00 c. Explain the consistency or lack of consistency in the answers to Requirements a & b. The consistency in the answers are so seeing that table 2 in appendix A appears to be the sum of the PV for each of the 3 years in table 1. Exercise 24-8A Determining the internal rate of return
Medina Manufacturing Company has an opportunity to purchase some technologically advanced equipment that will reduce the company’s cash outflow for operating expenses by $1,280,000 per year. The cost of the equipment is $6,186,530.56. Medina expects it to have a 10-year useful life and a zero salvage value. The company has established an investment opportunity hurdle rate of 15 percent and uses the straight-line method for depreciation.
a. Calculate the internal rate of return of the investment opportunity. Year
Discount Factor 1
(hurdle rate of 15)
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