Question

Question 1 – 8 marks – 13 minutes

Bernadette Inc. makes bacterial cultures for biology research experiments. She makes each batch by hand which takes a long time. She is thinking of buying a piece of equipment for $80,000 to automate her production and increase her sales. If she buys the machine, she will be able to increase her annual sales by $100,000 per year. The variable product costs associated with these extra sales will amount to $60,000 per year. The machine will require occasional maintenance which will cost $5,000 per year. At the end of the useful life of the equipment (in 10 years’ time), Bernadette will be able to sell the machine for $20,000.

Bernadette Inc. uses an interest rate of 4% in capital budgeting decision making.

Required:

1. What is the net present value of buying the equipment?
2. Should Bernadette buy the equipment? Why or why not?

Answer 1

Ans:

Cost of equipment : $80,000

Increase in Revenue : $100,000

Increase in Variable costs : $60,000

Maintainence : $5,000

Net Annual Inflow : $100,000 - $60,000 - $5,000 = $35,000

Life of equipment : 10 Years

Interest rate : 4%

Salvage Value : $20,000

Annuiny Factor Value @4% for 10 Years : 8.11090

PV Factor @4% for 10 Years : 0.67556

Present Value of Inflows: Annuiny Factor Value*Net Annual Inflow + PV Factor* Cost of equipment

= 8.11090*$35,000 + 0.67556*$20,000 = $297,392.67 or $297,393

NPV of buying the equipment : $297,393 - $80,000 = $217,393

NPV is positive, Project should be accepted.

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