Question

Exercise 11-6 Net present value LO P3 A new operating system for an existing machine is expected to cost $520,000 and have a useful life of six years. The system yields an incremental after-tax income of $150,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $10,000. A machine costs $380,000, has a $20,000 salvage value, is expected to last eight years, and will generate an after-tax income of $60,000 per year after straight-line depreciation. Assume the company requires a 10% rate of return on its investments. Compute the net present value of each potential investment. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

Answer 1

Answer:

NPV of investment 1: $509,131

NPV of investment 2: $269,513

Explanation:

initial investment -$520,000

6 year useful life, depreciation per year = ($520,000 - $10,000) / 6 = $85,000

free cash flow per year = $150,000 + $85,000 = $235,000

free cash flow last year = $235,00 + $10,000 = $245,000

NPV = -$520,000 + $235,000/1.1 + $235,000/1.1² + $235,000/1.1³ + $235,000/1.1⁴ + $235,000/1.1⁵ + $245,000/1.1⁶ = -$520,000 + $213,636 + $194,215 + $176,559 + $160,508 + $145,917 + $138,296 = $509,131

initial investment -$380,000

8 year useful life, depreciation per year = ($380,000 - $20,000) / 6 = $60,000

free cash flow per year = $60,000 + $60,000 = $120,000

free cash flow last year = $120,00 + $20,000 = $140,000

NPV = -$380,000 + $120,000/1.1 + $120,000/1.1² + $120,000/1.1³ + $120,000/1.1⁴ + $120,000/1.1⁵ + $120,000/1.1⁶ + $120,000/1.1⁷ + $140,000/1.1⁸= -$380,000 + $109,091 + $99,174 + $90,158 + $81,962 + $74,501 + $67,737 + $61,579 + $65,311 = $269,513