We need to have Pre-requisite knowledge about the following before attempting the calculation.
<u>Net Present Value</u> (NPV): It is the comparison between the net cash inflows received from a future investment and the cost of investment that the company had to pay at present that is the cost of the initial investment.
<u>Capital Budgeting</u>: The process of making capital investments decisions are called capital budgeting. Capital investments include investment in machinery, vehicle or information technology. .
<u>Initial investment</u>: It’s the amount that is invested in the startup of a project. It is also referred to as the initial outlay
<u>Discounted Cash Flow:</u> It is the Cash Flow which is discounted at the desired rate of interest.
<u>Cash Inflow</u>: Cash inflow can be termed as the flow of funds into the business from sales of goods and services, and investments. Cash inflow is necessary for the smooth flow of business activities. I
<u>Cash Outflows</u>: In accounting terms, cash outflows mean the transfer of funds by a business to its employees, suppliers, and creditors.
Compute the net present value of investment A by using the equation shown below:
- Net Present Value = $18,265.6 - $15,000
Hence, the net present value of investment A is computed $3,265.6.
Compute the present value of annual net cash flows using the equation shown below:
- Present Value = $8000 × 2.2832
Hence, the present value of annual net cash flows is $18,265.6
Here cash flows are changing or different throughout the span of 3 years that’s why the present value factor is used. Hence, the net present value of investment B at 15% for 3 years amounts to $780. Investment A is a better option than investment B because the NPV of investment A is higher.
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Correct Question - Alfarsi Industries uses the net present value method to make investment decisions and requires a 15% annual return on all investments. The company is considering two different investments. Each require an initial investment of $15,000 and will produce cash flows as follows: End of Year 1 2 Investment A В $8,000 $ 8,000 0 8,000 24,000 The present value factors of $1 each year at 15% are: 1 2 8.8696 0.7561 0.6575 The present value of an annuity of $1 for 3 years at 15% is 2.2832 Which investment should Alfarsi choose? Which investment should Alfarsi choose? Only Investment A is acceptable. Only Investment B is acceptable. Both investments are acceptable, but A should be selected because it has the greater net present value. Both investments are acceptable, but B should be selected because it has the greater net present value. O Neither machine is acceptable.