Question

Commercial Decor Pty Ltd is considering investing in a new machine to assemble its furniture. The machine is estimated to cost $150,000 which can last for 5 years before it becomes unreliable and can be sold for scrap at $12,000. The project is estimated to bring in additional $40,000 net cash inflow annually. The net cash flow in year 5 also includes the scrap value. The company uses a 13 per cent discount rate as the required rate of return on capital budgeting projects. Ignore income taxes.

Required

Round your answers to 2 decimal places.

(1) Calculate the net present value .

(2) Calculate the payback period (1 mark). If the target payback period is 3.5 years, will you recommend the company to accept this project, and why? (1 mark)

Answer 1

Answer :

1. Calculation of Net Present Value :

Net Present Value = Present value of annual cash inflow - Initial cash outflow

= [$40,000 x PVAF(13%,5years) + Scrap value x PVF(13%, 5th year)] - $150,000

= [($40,000 x 3.517) + ($12,000 x 0.542)] - $150,000

= [$140,680 + $6,504] - $150,000

= $147,184   - $150,000

= ($2,816)

2. Calculation of Payback Period :

Payback Period = Initial Investment / Net annual cash flow

Payback Period = $150,000 / $40,000

= 3.75 years

Recommendation : As already stated target payback period i.e 3.5 years is less than actual payback period of project i.e 3.75 years. Also Net present value of project iis negative.

Hence, Its not profiatable to accept the project.