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Chapter 26: Q15SE (page 1467)

Hicks Company is considering an investment opportunity with the following expected net cash inflows: Year 1, \(235,000; Year 2, \)195,000; Year 3, \(125,000. The company uses a discount rate of 6%, and the initial investment is \)365,000. Calculate the NPV of the investment. Should the company invest in the project? Why or why not?

Short Answer

Expert verified

The company must invest in the project as net present value is positive.

Step by step solution

01

Definition of Net Present Value

A metric that determines the present value of all the stream of cash inflows that will be received in the future period of time is known as net present value. It is also used in capital budgeting.

02

Calculation of net present value

Time

Particular

Net cash inflow

PV factor

Present value

Year 1

PV

$235,000

0.943

$221,605

Year 2

PV

$195,000

0.890

173,550

Year 3

PV

$125,000

0.840

105,000

Present value of cash inflows
$500,155
Less: Initial investment($365,000)
Net present value$135,155

Note: net present value of the project is positive reflecting that the business entity must invest in the project.

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Most popular questions from this chapter

Hudson Manufacturing is considering three capital investment proposals. At this time, Hudson only has funds available to pursue one of the three investments.

Equipment A

Equipment B

Equipment C

Present value of net cash inflows

\(1,647,351

\)1,969,888

\(2,064,830

Initial investment

(1,484,100)

(1,641,573)

(1,764,812)

NPV

\)163,251

\(328,315

\)300,018

Which investment should Hudson pursue at this time? Why?

Henry Co. is considering acquiring a manufacturing plant. The purchase price is \(1,200,000. The owners believe the plant will generate net cash inflows of \)325,000 annually. It will have to be replaced in six years. Use the payback method to determine whether Henry should purchase this plant. Round to one decimal place.

Use the Present Value of \(1 table (Appendix A, Table A-1) to determine the present value of \)1 received one year from now. Assume a 8% interest rate. Use the same table to find the present value of \(1 received two years from now. Continue this process for a total of five years. Round to three decimal places.

Requirements

1. What is the total present value of the cash flows received over the five-year period?

2. Could you characterize this stream of cash flows as an annuity? Why or why not?

3. Use the Present Value of Ordinary Annuity of \)1 table (Appendix A, Table A-2) to determine the present value of the same stream of cash flows. Compare your results to your answer to Requirement 1.

4. Explain your findings.

Mountain Manufacturing is considering the following capital investment proposals. Mountain’s requirement criteria include a maximum payback period of five years and a required rate of return of 12.5%. Determine if each investment is acceptable or should be rejected (ignore qualitative factors). Rank the acceptable investments in order from most desirable to least desirable

Project

A

B

C

D

E

Payback

3.15 years

4.20 years

2.00 years

3.25 years

5.00 years

NPV

\(10,250

\)42,226

(\(10,874)

\)36,251

$0

IRR

13.0%

14.2%

8.5%

14.0%

12.5%

Profitability index

1.54

1.92

0.75

2.86

1.00

Using payback, ARR, and NPV with unequal cash flows

Hughes Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machine at a cost of \(2,600,000. If refurbished, Hughes expects the machine to last another eight years and then have no residual value. Option 2 is to replace the machine at a cost of \)3,800,000. A new machine would last 10 years and have no residual value. Hughes expects the following net cash inflows from the two options:

Year

Refurbish current machine

Purchase new machine

1

\(1,760,000

\)2,970,000

2

440,000

490,000

3

360,000

410,000

4

280,000

330,000

5

200,000

250,000

6

200,000

250,000

7

200,000

250,000

8

200,000

250,000

9

250,000

10

250,000

Total

\(3,640,000

\)5,700,000

Hughes uses straight-line depreciation and requires an annual return of 10%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of these two options.

2. Which option should Hughes choose? Why?
See all solutions

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