Question

Uncertain Future Cash Flows

Hanover Industries is investigating the purchase of automated equipment that would save $100,000 each year in direct labour and inventory carrying costs. This equipment costs $750,000 and is expected to have a 10-year useful life with no salvage value. The company requires a minimum 15% rate of return on all equipment purchases. This equipment would provide intangible benefits (such as greater flexibility and higher-quality output) that are difficult to estimate and yet are quite significant.

Required:

(Ignore income taxes.)

What dollar value per year would the intangible benefits have to be worth in order to make the equipment an acceptable investment?

Answer 1

Item	Year(s)	Amount of Cash Flows	15% Factor	Present Value of Cash Flows
Cost of the equipment	Now	$(750,000)	1.000	$(750,000)
Annual cost savings	1-10	$100,000	5.019	$501,900
Net present value				$(248,100)

The annual value of the intangible benefits would have to be large enough to offset the $248,100 negative present value for the equipment. This annual value can be computed as follows:

NPV/10 year, 15% annuity factor:

$248,100/5.019 = $49,432