Question

A. A new operating system for an existing machine is expected to cost $684,000 and have a useful life of six years. The system yields an incremental after-tax income of $200,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $60,000.
b. A machine costs $480,000, has a $40,000 salvage value, is expected to last eight years, and will generate an after-tax income of $110,000 per year after straight-line depreciation.

Required:
Assume the company requires a 10% rate of return on its investments. Compute the net present value of each potential investment.

Answer 1

Answer:

NPV for A = $673,867.69

NPV for B = $418,923.12

Explanation:

Net present value is the present value of after-tax cash flows from an investment less the amount invested.  

NPV can be calculated using a financial calculator  

For A

It is cash flows not income that is used to determine net present value.

Cash flow = net income + depreciation

Straight line depreciation expense = (Cost of asset - Salvage value) / useful life

($684,000 - $60,000) / 6 = $104,000

$200,000 + $104,000 = $304,000

Cash flow in year 0 = $-684,000  

Cash flow each year from year 1 to 5   = $304,000

Cash flow in year 6 = $304,000 + $60,000 = $364,000  

I = 10 %

NPV = $673,867.69

B

Straight line depreciation expense = (Cost of asset - Salvage value) / useful life

($480,000 - $40,000) / 8 = $55,000

$110,000 + $55,000 = $165,000

Cash flow in year 0 = $-480,000  

Cash flow each year from year 1 to 7   = $165,000

Cash flow in year 8 = $165,000 + $40,000 = $205,000  

I = 10 %

NPV = $418,923.12

To find the NPV using a financial calculator:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. after inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.  

3. Press compute