Module 4 – Homework Questions and Answers
[Link] on a new machine
A small industrial machine costs $100 000 and is expected to earn annual net cash inflows of
$44 000, $40 000, $36 000 and $32 000, before it wears out sufficiently to be unreliable and
must be sold for an estimated $10 000.
Required:
a. If funds earn 10 per cent, what is its NPV?
b. If funds earn 15 per cent, what is its NPV?
c. Advise management on the purchase of the machine.
($100 000) $44 000 $40 000 $36 000 $10 000
$32 000
Year 0 1 2 3 4
a.
NPV = Present Value of Net Cash Flows – Initial Cost
Discount rate is 10%
Present Value of Net Cash Flows using factors from the Present Value table for $1 at the end of
N periods:
PV1 = $44 000 x 0.909 = $39 996
PV2 = $40 000 x 0.826 = $33 040
PV3 = $36 000 x 0.751 = $27 036
PV4 = ($10 000 + $32 000) x 0.683 = $28 686
$128 758
NPV = $128 758 - $100 000 = $28 758
b.
Discount rate is 15%
Present Value of Net Cash Flows using factors from the Present Value table for $1 at the end of
N periods:
PV1 = $44 000 x 0.870 = $38 280
PV2 = $40 000 x 0.756 = $30 240
PV3 = $36 000 x 0.658 = $23 688
PV4 = ($10 000 + $32 000) x 0.572 = $24 024
$116 232
NPV = $116 232 - $100 000 = $16 232
c. Both discount rates result in a positive NPV, therefore it is advisable for management to
invest in this small industrial machine.
2. Deciding on improving a process
An improvement to the process in a men’s shirt factory will cost $1.5 million but will result in
net cost savings of $450 000 annually for the next ten years.
Required:
a. If funds are worth 10 per cent, what is the NPV for the investment?
b. If the shirt factory process improvements turn out to cost $2 million, are the process
changes still worth making?
a.
NPV = Present Value of Net Cash Flows – Initial Cost
Discount rate is 10%
Net Cash Flow is $450 000 annually for 10 years, therefore the Present Value of Annuity factors
table can be used.
Present Value of Net Cash Flows = $450 000 x 6.145 = $2 765 250
NPV = $2 765 250 - $1 500 000 = $1 265 250
The process improvements should be completed as the NPV is positive.
b.
Yes, the process changes are still worth making as there is still a positive NPV when the initial
cost increases to $2 000 000.
NPV = $2 765 250 - $2 000 000 = $765 250
3. Payback Period (PP)
A machine costing $102 700 is estimated to have a useful life of 5 years and is estimated to
produce the following annual net cash inflows:
Year Annual Net
Cash Inflow
1 $21 600
2 $28 200
3 $31 600
4 $38 200
5 $42 000
Required:
Calculate the payback period for the investment.
Year Net Cash Flow Cumulative Net
Cash Flow
0 ($102 700) ($102 700)
1 $21 600 ($81 100)
2 $28 200 ($52 900)
3 $31 600 ($21 300)
4 $38 200 $16 900
5 $42 000 $58 900
Payback occurs between years 3 and 4.
Calculating the exact payback period in years and months:
At the end of year 3 there is $21 300 of the initial investment left to be paid back and during
year 4 the net cash inflow is $38 200.
Payback period = 3 years + (21 300 ÷ 38 200 years)
= 3.56 years
