Question

You are also considering another project that has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the project’s estimated cash flows: (Please show work and Excel formulas for calculations)

Year Initial Investment and Operating Cash Flows End-of-YearNet Salvage Value

0 -5,000 $5000

1 2100 3100

2 2,000 2,000

3 1,750 0

Using the 10% cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at theend of Year 2? At the end of Year 1? What is the project’s optimal (economic) life?

Answer 1

Project’s NPV if it is operated for the full 3 years

Year	CF	PVF@10%	Disc CF
0	$-5,000.00	1	-5000
1	$ 2,100.00	0.9091	$ 1,909.09
2	$ 2,000.00	0.8264	$ 1,652.89
3	$ 1,750.00	0.7513	$ 1,314.80
NPV	$    -123.22

Project Operated for 2 years
Year	CF	PVF@10%	Disc CF
0	$-5,000.00	1	$-5,000.00
1	$ 2,100.00	0.9091	$ 1,909.09
2	$ 2,000.00	0.8264	$ 1,652.89
2	$ 2,000.00	0.8264	$ 1,652.89
NPV	$     214.88

Change in NPV = 214.88 - (-123.22)

= $ 338.09

Project Operated for 1 year
Year	CF	PVF@10%	Disc CF
0	$-5,000.00	1	$-5,000.00
1	$ 2,100.00	0.9091	$ 1,909.09
1	$ 3,100.00	0.9091	$ 2,818.18
NPV	$    -272.73

Change in NPV = -271.73 - (-123.22)

= - $ 149.51

The optimal economic life of the asset will be 2 years, as the NPV of the project is positive at economic life 2 years

Pls do rate, if the answer is correct and comment, if any further assistance is required.