Question

These questions are linked. Please solve this.

1. Duke Manufacturing, Inc. is considering investing in a cutting-edge equipment costing $1,000,000, with a useful life of 6 years and zero salvage value. Annual depreciation using the straight-line method is $166,667. Projected annual net income for each of the six years is $220,000. Using the net present value method at a discount rate of 10%, what should Duke do with respect to this potential investment?

a. Accept

1. 2. Reject
   3. Accept only if there is salvage value
   4. Insufficient information to conclude
2. How would your answer be different if instead the useful life of the equipment above is only 4 years and it’s more accurate to discount the annual cash flow at 15%? (Note: All other data is the same except the straightline depreciation should be computed over 4 years).
   1. Accept
   2. Reject
   3. Accept only if there is salvage value
   4. Insufficient information to conclude
3. Using the information in the above problem, what if Duke’s net income in each of the succeeding 4 years is: $180,000 year 1; $220,000 year 2; $250,000 year 3; and $280,000 year 4? All other data is the same.
4. 1. Accept
   2. Reject
   3. Accept only if there is salvage value
   4. Insufficient information to conclude

Answer 1

Year	Particulars	PVF	Net profit	Depreciation	Cash flows	Present value of cash flows
0	Cash outfow	$1.00			($1,000,000.00)	($1,000,000.00)
1	Cash inflow	$0.91	220000	166667	386667	$351,515.45
2	Cash inflow	$0.83	220000	166667	386667	$319,559.50
3	Cash inflow	$0.75	220000	166667	386667	$290,508.64
4	Cash inflow	$0.68	220000	166667	386667	$264,098.76
5	Cash inflow	$0.62	220000	166667	386667	$240,089.79
6	Cash inflow	$0.56	220000	166667	386667	$218,263.44
	NPV of machine					$684,035.59
Option A is correct, as NPV of machine is $684035.59 hence Machine should be purchased
Year	Particulars	PVF	Net profit	Depreciation	Cash flows	Present value of cash flows
0	Cash outfow	$1.00			($1,000,000.00)	($1,000,000.00)
1	Cash inflow	$0.87	220000	166667	386667	$336,232.17
2	Cash inflow	$0.76	220000	166667	386667	$292,375.80
3	Cash inflow	$0.66	220000	166667	386667	$254,239.83
4	Cash inflow	$0.57	220000	166667	386667	$221,078.11
	NPV of machine					$103,925.92
Option A, i.e. invest in machine as NPV of machine is still positive even if discount rate is 15% and life of project is only 4 years.
Year	Particulars	PVF	Net profit	Depreciation	Cash flows	Present value of cash flows
0	Cash outfow	$1.00			($1,000,000.00)	($1,000,000.00)
1	Cash inflow	$0.87	180000	166667	346667	$301,449.57
2	Cash inflow	$0.76	220000	166667	386667	$292,375.80
3	Cash inflow	$0.66	250000	166667	416667	$273,965.32
4	Cash inflow	$0.57	280000	166667	446667	$255,383.31
	NPV of machine					$123,173.99
Option A, i.e. invest in machine as NPV of machine is still positive.
Hence, Accept the offer.