Question

The management of Kunkel Company is considering the purchase of a $30,000 machine that would reduce operating costs by $6,500 per year. At the end of the machine’s five-year useful life, it will have zero salvage value. The company’s required rate of return is 12%.

Click here to view Exhibit 7B-1 and Exhibit 7B-2, to determine the appropriate discount factor(s) using table.

Required:

1. Determine the net present value of the investment in the machine.

2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the machine?

Answer 1

1. Net Present Value(NPV) of the investment of Machine:

Years	Particulars	Expected Cash Outflow/Inflow	PV of $1 at 12%	PV of cash outflow
0	Purchase Cost of machine	-$30000	1	=-$30000*1 =-$30000
1 to 5 Years (annuity Factor)	Annual operating Savings	$6500	3.6048	=$6500*3.6048 =23431.2
	Net present value of cash flows			-$6568.8

Since the NPV is negative ,it is not advisable to invest in the machine.

2. The difference in cash inflows and cash outflows:

Total Cash Outflows=Cost of the machine=$30000

Total Cash Inflows= Annual Operating Savings = $6500* 5 Years = $32500

Net Cash Inflow = $32500-$30000=$2500

The net cash inflow is positive when the time value of money is not considered (undiscounted cashflow) which means the oportunity cost has not been considered i.e if we will invest $30000 dollar in some other purpose we will get 12% return and when the time value of money is considered the NPV of Cash inflows is less than the cash outflow which means that the proposal should not be accepted as we could not earn the minimum desired rate of return i,e 12% .