Question

1. You are the manager of a local factory that produces plastic bottles for soft drink manufacturers. Your assistant comes to you with exciting news about a new assembly line for the company. He presents the following data to you that he’s researched:

            Estimated life of assembly line:                 3 years

            Initial investment cost:                               $500,000

            Estimated salvage value:                            none

            Estimated Cash Flow Analysis

            Year                                        Expected Cash Flow

            1                                              $250,000

            2    190,000

            3                                              80,000

a) If the current interest rate is 5 percent, use net present value analysis to determine whether or not the company should purchase this new machine.

b) If the expected cash flow from Year 3 was $60,000 instead of $80,000, I would know that we should reject this project (at a 5 percent interest rate) without even calculating net present value. How do I know that?

Answer 1

Ans: (a) If we use Net present value analysis (NPV) to determine whether the company should purchase the machine or not;  

NPV = PV of Cash Inflows - PV of cash Outflows

= 479,537.83 - 5,00,000

= - 20,462.47 which means that NPV is negative. The company should not purchase this new machine as the inflows are less than the outflow.

PV of Cash Outflow = Initial Investment = 5,00,000

Present value of Cash Inflows = A₁/(1+i) + A₂/ (1+i)² + A₃/ (1+i)³

= 2,50,000/ 1+0.05 + 1,90,000/ (1+0.05)² + 80,000/ (1+ 0.05)³

= 2,38,095.23 + 172,335.60 + 69,107 = 479,537.83

Where A₁, A₂ , A₃ are the expected cash inflows to be obtained in 3 years and  i = current Interest rate

(b) If the cash flow from the 3rd year were 60,000 instead of 80,000 it implies that PV of cash inflows has been reduced given the same interest rate and NPV will decline because the PV of Cash inflows has been reduced and it is not profitable to invest in the project because the cash that is generated from investing in the machine is less now.