Question

We are thinking of investing in a piece of equipment that costs $190,000. It should generate the following income and expenses each year for five years, and have no salvage at the end of its five years of estimated life. Revenue 250,000 Cost of Goods sold -130,000 Gross Profit 120,000 Selling and admin (includes $15,000 of depreciation) -85,000 Net income per year 35,000

a. What is the cash flow per year, of the investment?

b. What is the Net Present Value (NPV) of the project, if the project requires a 10% return on our investment? (Assume the Present Value factor of an equal annual cash flow (annuity) at 10% for five (5) years is 3.7908)

c. Should we accept or reject this project?

Answer 1

a) For calculating cash flows per year, we need to add back depreciation charge from the net income because, depreciation is a non cash expense and do not involve any cash outlay. For other expenses or incomes, there will be cash inflow or outflow.

Cash flows per year = Net income + Depreciation

= $35000 + $15000

=$50000

b) Net Present Value = Present value of cash inflows - Initial investment

Present value of cash inflows = Present value of annuity of 5 years at 10% * $50000  

= 3.7908 * $50000 = $189540

Initial investment = $190000

Net present value = $189540 - $190000 = ($460)

c) Since the net present value of the project is negative (460), means present value of cash infows is less than present value of cash outflows, we should reject this project.