Question

A company is evaluating the feasibility of investing in machinery to manufacture an automotive component. It would need to make an investment of $560,000 today, after which, it would have to spend $7,500 every year starting one year from now, for ten years. At the end of the period, the machine would have a salvage value of $11,000. The company confirmed that it can produce and sell 7,500 components every year for ten years and the net return would be $12.70 per component. The company's required rate of return is 7.00%.

a. What is the Net Present Value (NPV) of this investment option?

Round to the nearest cent

b. Is the investment option feasible?

Yes

No

Answer 1

A) What is the Net Present Value (NPV) of this investment option?

Answer: $7,795.98

B) Is the investment option feasible?

Yes

Since NPV is greater than zero, option is feasible. We company choose this option it will profitable.

Workings

Formula for calculating Net Present Value is as follows

NPV = Present Value of Future cash flows – Initial investment

Initial investment             = $560,000

Present value of future cash flows, we need to calculate cash flow for 10 years. Present value of a cash flow can be found out using the following formula.

Present Value = Cash flow ÷ (1+ R)^N

Where,

R = required rate of return = 9% given in problem.

N = number of years

Present value of future cash flows calculation

Year	Revenue	Operating Cost	Net Cash Flow (i.e. Revenue – Operating Cost)	Workings for present Value	Present Value
1	95,250	7,500	87,750	=87,750 ÷(1.09)1	80,504.59
2	95,250	7,500	87,750	=87,750 ÷(1.09)2	73,857.42
3	95,250	7,500	87,750	=87,750 ÷(1.09)3	67,759.10
4	95,250	7,500	87,750	=87,750 ÷(1.09)4	62,164.31
5	95,250	7,500	87,750	=87,750 ÷(1.09)5	57,031.48
6	95,250	7,500	87,750	=87,750 ÷(1.09)6	52,322.46
7	95,250	7,500	87,750	=87,750 ÷(1.09)7	48,002.25
8	95,250	7,500	87,750	=87,750 ÷(1.09)8	44,038.77
9	95,250	7,500	87,750	=87,750 ÷(1.09)9	40,402.54
10	106,250	7,500	98,750	=98,750 ÷(1.09)10	41,713.07
Present value of future cash flows	567,795.98

Note:

1. Revenue for year 1 to 9 = Number of component produced * net revenue per component

= 7500 * $12.70

=95,250

2. Cash flow in year 10 not only include revenue from components but also salvage value of equipment. Therefore total cash flow of year 10 = Revenue from components + salvage value of machinery

= 95,250 + 11,000

=106,250

NPV Calculation

NPV     = Present Value of Future cash flows – Initial investment

                = 567,795.98 - 560,000

            =$7,795.98

Decision

Since NPV is positive (i.e. greater than zero) this option is feasible.