Question

Brigham & Ehrhardt, Financial Management Theory and Practice, 15th ed. pg. 449-451, CH 10, Minicase

Question Part L.

l. You are also considering another project that has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a salvage value. Here are the project's estimated cash flows:

	Year	Initial Investment and Operating Cash Flows			End-of-Year                                    Net Salvage Value
	0	-5000			5000
	1	2100			3100
	2	2000			2000
	3	1750			0
Calculate and determine, using the 10% cost of capital, what is the project's NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the projects's optimal (economic) life?
Rate	10%
	Year
	0
	1
	2 3

Answer 1

No termination :

Note : no salvage value added

We can use the financial calculator

Press CF

CF0 = -5000

CF1 = 2100

F01 = 1

CF2 = 2000

F02 = 1

CF3 = 1750

F03 = 1

Press NPV

I = 10

Press down arrow and then press CPT

we get NPV as -123.21

Termination after year 2 :

CF0 = -5000

CF1 = 2100

F01 = 1

CF2 = 2000 + 2000 = 4000 (salvage value added)

F02 = 1

Press NPV

I = 10

Press down arrow and then press CPT

we get NPV as 215

Termination after 1 year :

CF0 = -5000

CF1 = 2100 + 3100 = 5200

F01 = 1

We get NPV as - 273

The project is only acceptable if it operates for two years.

Neverthless it should also be noted that the project’s economic life does not always equal the engineering life.