Question

Superserv Inc. intends to acquire new equipment for $10 million and has an estimated life of 5 years and a salvage value of $800K.  The new equipment is expected to allow additional annual sales of $5 million over the next 5 years.  The associated additional annual operating costs are expected to be $3 million, while the interest on debt issued to finance the project is $1.5 million.   In addition, working capital will increase by $1.2 million at the outset. The project's cost of capital is 10%.  The firm's tax rate is 40%.  The annual depreciation charge on the new machine is $2 million.  What is the project's NPV? ($-2.5753m)

Solve this without excel, please.

Answer 1

NPV represents Net present value which is used to evaluate capital investment.
Net present value is calculated as present value of cash inflow less present value of cash outflow.
If NPV of project is positive then project should be accepted as there is positive cash inflow and if NPV is negative the project should be rejected as there is cash outflow.
Calculation of net present value of project is shown below						In millions
Year	0	1	2	3	4	5
Annual sales		$5.00	$5.00	$5.00	$5.00	$5.00
Operating costs		-$3.00	-$3.00	-$3.00	-$3.00	-$3.00
Depreciation		-$2.00	-$2.00	-$2.00	-$2.00	-$2.00
Income before taxes		$0.00	$0.00	$0.00	$0.00	$0.00
Taxes @ 40%		$0.00	$0.00	$0.00	$0.00	$0.00
Net income		$0.00	$0.00	$0.00	$0.00	$0.00
Add: Depreciation		$2.00	$2.00	$2.00	$2.00	$2.00
Operating cash flow		$2.00	$2.00	$2.00	$2.00	$2.00
After tax salvage value						0.48	0.80*(1-0.40)
Working capital recovery						$1.20
Purchase of equipment	-$10.00
Working capital	-$1.20
Net cash flow (a)	-$11.20	$2.00	$2.00	$2.00	$2.00	$3.68
Discount factor @ 10% (b)	$1.00000	$0.90909	$0.82645	$0.75131	$0.68301	$0.62092
	1/(1.1^0)	1/(1.1^1)	1/(1.1^2)	1/(1.1^3)	1/(1.1^4)	1/(1.1^5)
Present value (a*b)	-$11.20	$1.82	$1.65	$1.50	$1.37	$2.28
Net present value	-$2.5753
Thus, net present value of project is -$2.5753 million.