Question

You must show your work on all mathematical questions and I must be able to follow your steps.

You are the manager of a local factory that produces plastic bottles for soft drink manufacturers. Your assistant comes to you with exciting news about a new assembly line for the company. He presents the following data to you that he’s researched:

            Estimated life of assembly line:                 4 years

            Initial investment cost:                                   $800,000

            Estimated salvage value:                                none

            Estimated Cash Flow Analysis

            Year                                        Expected Cash Flow

            1                                              $350,000

            2                                              240,000

            3                                              220,000

            4                                              105,000

                                                            $915,000

a) Your assistant thinks you should buy the new assembly line based on the information he has gathered. You are not so sure as of yet. How would you educate your assistant on decisions such as this?

b) Given the correct response to part a), do you think the firm should buy this machine if the current interest rate is 12 percent? Why or why not? How did you come to this decision?

Answer 1

(A) The assistant has taken the following consideration:

That the cost of Setting up the new assemble line is $800,000

And the cash flows from setting up new line is $350000 in Year 1, $240000 in Year 2, $220000 in Year 3 and $105000 in Year 4, which in total is $915,000

So, it might appear that the cost is $800,000 and the Profit over 4 years is $915,000, so the deal is profitable.

But what we need to understand is that there is a time value of money as well. The value of 1$ today might not be the same tomorrow due to several factors like inflation etc.

Hence, to make a decision, we need to consider the Net Present Value of all the cash flow and compare it to the Present cost. Then only we can decide if the proposal is profitable or not.

(B) We will find the Net Present Value (NPV) in this case. If NPV is positive, we will buy the machine, if NPV is negative, we will not buy the machine.

Considering i=12%,

Cash Flow in Year 0 = -$800,000 {It is cost hence it is taken as negative}

And the cash flows from setting up new line is $350000 in Year 1, $240000 in Year 2, $220000 in Year 3 and $105000 in Year 4

Year(n)	Amount	Present Value Factor= 1/(1+i)^n	Present Value= Present Value Factor*Amount
0	-800000	1	-800000
1	350000	0.892857143	312500
2	240000	0.797193878	191326.5306
3	220000	0.711780248	156591.6545
4	105000	0.635518078	66729.39823
Net Present Value(NPV)=SUM of all present values	-72852.41664

Since the Net Present Value (NPV) is negative, hence we will not buy the machine.