Question

BASIC NET PRESENT VALUE ANALYSIS

Cornell Green, process engineer, knows that the acceptance of a new process design will depend on its economic feasibility. The new process is designed to improve environmental performance. On the negative side, the process design requires new equipment and an infusion of working capital. The equipment will cost $300,000, and its cash operating expenses will total $60,000 per year. The equipment will last for seven years but will need a major overhaul costing $30,000 at the end of the fifth year. At the end of seven years, the equipment will be sold for $24,000. An increase in working capital totalling $30,000 will also be needed at the beginning. This will be recovered at the end of the seven years.

On the positive side, Cornell estimates that the new process will save $135,000 per year in environmental costs (fines and cleanup costs avoided). The cost of capital is 10 percent.

Required:

1. Prepare a schedule of cash flows for the proposed project. Assume that there are no income taxes.

2. Compute the NPV of the project. Should the new process design be accepted?

Answer 1

Net present value is difference between total of present value of cash inflows and salvage value and initial cost of investment. discount factors are used to find present value of future cash inflows.

cost of investment = cost of equipment+working capital+overhaul cost

schedule of cash flows for the proposed project :

years
0	equipment cost	($300,000)
0	working capital	($30,000)
5	overhaul cost	($30,000)
1-7	Net cash flow [ cost saved-cost][$135,000-$60,000]	$75,000
7	salvage value	$24,000
7	working capital received back	$30,000

2. Compute the NPV of the project.

years	cash flow	PV factor @ 10%	present value of cash flow
0	($300,000)	1	($300,000)
0	($30,000)	1	($30,000)
5	($30,000)	0.62092	($18,628)[$30000*0.62092]
1-7	$75,000	4.86842 [1/1.10]1+[1/1.10]2+[1/1.10]3+[1/1.10]4+[1/1.10]5+[1/1.10]6+[1/1.10]7	$365,132 [75000*4.86842]
7	$24,000	0.51316[1/1.10]7	$12,316[24000*.51316]
7	$30,000	0.51316[1/1.10]7	$15,395[30000*0.51316]
		Net Present Value [365132+12316+15395-18628-30000-300000]	$44,215

Yes the new process design should be accepted as the net present value is positive.

present value of cash inflow is higher than initial cost.