Question

Exercise 11-6 Net present value LO P3

a. A new operating system for an existing machine is expected to cost $520,000 and have a useful life of six years. The system yields an incremental after-tax income of $150,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000.

Cash Flow Select Chart Amount x PV Factor = Present Value Annual cash flow = $0 Residual value = 0

b. A machine costs $380,000, has a $20,000 salvage value, is expected to last eight years, and will generate an after-tax income of $60,000 per year after straight-line depreciation.

Cash Flow Select Chart Amount x PV Factor = Present Value Annual cash flow = $0 Residual value = 0

Assume the company requires a 10% rate of return on its investments. Compute the net present value of each potential investment. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

Answer 1

Solution:

Part A: All Amount used in the answer in $

Calculation of NPV

Particular	PVF @10%		Amount in $
Cost of operating system (Initial cost) (A)	0 period of time		520,000
Less
Incremental cash flows after tax (B)	1-6 year	150,000 * 4.355	653,250
Salvage value (C)	6 year	10,000 * 0.5645	5,645
NPV (B+C) - A			138,895

Comment: This Investment is with Positive NPV.

Note: Depreciation is not considered here for the calculation of NPV. If you want to consider that depreciation because of its nature of noncash item then treatment will be: Depreciation of (520,000-10,000)/6 = 85,000 added back to incremental cash flow after tax each year.

Part B.

Particular	PVF @ 10%		Amount in $
The initial cost of investment (A)	1	380,000 * 1	380,000
Incremental Cash Flow (B)	1-8	60,000 * 5.335	320,100
Salvage Value (C)	8	20,000 * 0.4665	9,330
NPV (B+C) - A			- 50,570

Comment: This Investment opportunity is with Negative NPV.

Note: Depreciation is not considered here for the calculation of NPV.

Anser Changes If you want to consider that depreciation because of its nature of noncash item then treatment will be: Depreciation of (380,000-20,000)/8 = 45,000 added back to incremental cash flow after tax. Then Incremental cash flow will be ( 60,000+ 45,000) = 105,000 and Present value will be 105,000 * 5.335 = 560,175 Plus salvage value 9,330 total Inflow will be $ 569,505 N.PV = 569,505 - 380,000 = 189,505 then NPV is positive.