Question

Cardinal Company is considering a five-year project that would require a $2,890,000 investment in equipment with a useful life of five years and no salvage value. The company’s discount rate is 12%. The project would provide net operating income in each of five years as follows: Sales $ 2,739,000 Variable expenses 1,100,000 Contribution margin 1,639,000 Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 641,000 Depreciation 578,000 Total fixed expenses 1,219,000 Net operating income $ 420,000 part 1. If the equipment had a salvage value of $300,000 at the end of five years, would you expect the project's net present value to be higher, lower, or the same? part 2. If the company’s discount rate was 14% instead of 12%, would you expect the project's net present value to be higher, lower, or the same? part 3. What is the project’s net present value?

Answer 1

Calculation of NPV of project when project has zero salvage value and discount rate is 12%

NPV of project = Present value of future operating cash flows - Initial investment in the project

Operating cash flow per year = Net operating income + depreciation = $420000 + $578000 = $998000

Present value of annuity of $1 @ 12% for 5 years = 3.604776

Present value of future operating cash flows = $998000*3.604776 = $35,97,566.65

NPV of project = $35,97,566.65 - $28,90,000 = $7,07,566.65

Calculation of NPV of project when project has salvage value of $300000 and discount rate is 12%

NPV of project = Present value of future operating cash flows + Present value of salvage value - Initial investment in the project

Present value of salvage value = $300000 * (1+0.12)^-5 = $1,70,228.06

NPV of project = $35,97,566.65 + $1,70,228.06 - $28,90,000 = $8,77,794.71

Calculation of NPV of project when project has zero salvage value and discount rate is 14%

NPV of project = Present value of future operating cash flows - Initial investment in the project

Present value of annuity of $1 @ 14% for 5 years = 3.433081

Present value of future operating cash flows = $998000*3.433081 = $34,26,214.81

NPV of project = $34,26,214.81 - $28,90,000 = $5,36,214.81

Calculation of NPV of project when project has salvage value of $300000 and discount rate is 14%

NPV of project = Present value of future operating cash flows + Present value of salvage value - Initial investment in the project

Present value of salvage value = $300000 * (1+0.14)^-5 = $1,55,810.60

NPV of project = $34,26,214.81 + $1,55,810.60 - $28,90,000 = $6,92,025.41

Answer Part 1

If the equipment had a salvage value of $300,000 at the end of five years, NPV would be higher.

Answer Part 2

If the company’s discount rate was 14% instead of 12%, NPV would be lower.

Answer Part 3

Project's NPV = $7,07,566.65