Question

A firm wants to buy a machine that will last three years. Its initial cost is $3 million. It can borrow the money at 5% interest per year. They estimate they will increase revenues by $500,000 in the first year, $500,000 in the second year and $2.5 million in the third year. What is the Net Present Value of this investment if they use a discount rate of 4%?

Answer 1

Annual loan repayment ($) = Loan amount / P/A(5%, 3) = 3,000,000 / 2.7232 = 1,101,645

Annual net benefit = Increase in revenue - Loan repayment

Annual net benefit, year 1 ($) = 500,000 - 1,101,645 = - 601,645

Annual net benefit, year 2 ($) = 500,000 - 1,101,645 = - 601,645

Annual net benefit, year 3 ($) = 2,500,000 - 1,101,645 = 1,398,355

NPV ($) = - 601,645 x P/A(4% 2) + 1,398,355 x P/F(4%, 3)

= - 601,645 x 1.8861 + 1,398,355 x 0.8890

= - 1,134,762.64 + 1,243,137.60

= 108,374.96

NOTE: It is assume that loan will be repaid over the project life of 3 years.