Question

A wholesale distributor of automobile spare parts plans to modify the material handling

system of its existing facility. The facility will require an initial redesign cost of $370,000 and a

monthly operating and maintenance cost of $30,000. It will have a $66,500 salvage value of the

system after 7 years. the company's minimum attractive rate of return is 6% per year, compounded monthly?

If the wholesale distributor has a $2,500,000 investment budget, do you think that the distributor will make this investment?

Answer 1

Since the given required interest rate is compounded monthly, the effective monthly rate is 6%/12=.5%.

Now, he will ivnest as long as the net present value (NPV) at this interest rate is not higher than -2500000. So lets calculate the NPV now.

We will calculate cashflow on monthly level. The whole cashflow, with NPV at the end, is shown below.

The last month is positive because it includes the salvage of 66500.

NPV has been calculated at a rate of .5% monthly, from the formula =NPV(rate,cashflow)+initial investment.

As we can see that the NPV is lower than the budget of 2500000. Hence the project will be undertaken.

The NPV can also be calculated manually by the following formula

NPV=Initial investment+Cashflow1/(1+r)+cashflow2/(1+r)²+....+Cashflown/(1+r)ⁿ

where r is the interst rate (monthly), n is the number of months.