Question

Your company is looking at updating its production process by adding a new piece of equipment. The company uses a 9% cost of capital in its capital budgeting decisions. The new equipment will cost $350,000 and the company expects the following annual cash flows for 5 years as a result of the purchase (note that year 1 is negative): Year 1 (10,000) Year 2 45,000 Year 3 127,000 Year 4 168,000 Year 5 145,000 A) Calculate the Net Present Value (NPV) of the acquisition project. B) Calculate the Internal Rate of Return (IRR) of the acquisition project. C) Should the company purchase the new equipment? Explain.

Answer 1

Year	Cash Flow	PV factor @ 9% i.e ((1/1.09)^n)	PV of cash flow @ 7%(CF x PV factor)	PV factor @ 5% i.e ((1/1.05)^n)	PV of cash flow @ 5%(CF x PV factor)
0	$             (350,000)	1	$       (350,000.00)	1	$       (350,000.00)
1	$               (10,000)	0.9174	$           (9,174.31)	0.9524	$           (9,523.81)
2	$                 45,000	0.8417	$           37,875.60	0.9070	$           40,816.33
3	$               127,000	0.7722	$           98,067.30	0.8638	$         109,707.38
4	$               168,000	0.7084	$         119,015.44	0.8227	$         138,214.02
5	$               145,000	0.6499	$           94,240.05	0.7835	$         113,611.29
			$           (9,975.92)		$           42,825.20
Formula				workings	Answer
NPV = PV of cash inflows and outflows @ 9%					-9975.92
IRR= lower discount rate+[NPV @ lower rate/difference between NPV of lower rate and higher rate]*[higher dicount rate-lower discount rate]				= 0.05+[42825.2/42825.2-(-9975.92)]*[0.09-0.05]	8.24%

The company should not purchase the new equipment since the NPV is negative. It is recommended not to purchase the new equipment.