Question

A firm is considering the purchase of a $500,000 machine for its business. The machine is expected to increase sales by $237,000. The machine will have a 5 year useful life and will be depreciated over 5 years via the straight line method. There is no salvage value. The firm has a required rate of return of 10% for all new capital investments. The project's pro forma income statement is shown below:
Sales $237,000
Total Cost 137,000
Depreciation 100,000
EBIT $0
Taxes 0
Net income $0

The firm should: ___________

a. Accept the project because the NPV is $2,543
b. Accept the project because the NPV is $10,011
c. Reject the project because the NPV is negative $120,921
d. Reject the project because the NPV is negative $500,000
e. It doesnt matter since the NPV is 0
f. Cant tell since there isnt enough information

Answer 1

Answer:

The firm should: ___________

c. Reject the project because the NPV is negative $120,921

Explanation:

a) Data and Calculations:

Pro Forma Income Statement:

Sales           $237,000

Total Cost      137,000

Depreciation 100,000

EBIT              $0

Taxes             0

Net income $0

Cost of machine = $500,000

Required rate of return = 10%

Annual revenue from new machine = $237,000

Annual operational costs = $137,000

Annual net cash flow = $100,000

Depreciation expense = $100,000

Annuity factor at 10% for 5 years = 3.791

PV Annuity of $100,000 = $100,000 * 3.791 = $379,100

NPV = $379,100 - $500,000 = $120,900

b) The Net present value of the project is $120,900 (the difference between the total present value of cash inflow of $379,100 and the initial cash outflow of $500,000).