Selection of Purchase alternatives under NPV.
Prince Company's required rate of return is 10%. The company is considering the purchase of three machines, as indicated below. Consider each machine independently.
Required:
a. Machine A will cost $25,000 and have a life of 15 years. Its salvage value will be $1,000, and cost savings are projected at $3,500 per year. Compute the machine's net present value.
b. How much will Prince Company be willing to pay for Machine B if the machine promises annual cash inflows of $5,000 per year for 8 years?
c. Machine C has a projected life of 10 years. What is the machine's internal rate of return, to the nearest whole percent, if it costs $30,000 and will save $6,000 annually in cash operating costs? Would you recommend purchase? Explain.
$1,860
|
a
|
|
Year
|
Amount
|
10% Factor
|
Present Value
|
|
|
Investment required
|
now
|
($25,000)
|
1
|
($25,000)
|
|
|
Annual cost savings
|
1-15
|
$3,500
|
7.606
|
26,621
|
|
|
Salvage value
|
15
|
$1,000
|
0.239
|
239
|
|
|
Net present value
|
|
|
|
$1,860
|
|
|
|
|
|
|
|
b
|
|
Year
|
Amount
|
10% Factor
|
Present Value
|
|
|
Annual cash inflows
|
1-8
|
$5,000
|
5.335
|
$26,675
|
Since the present value of the cash inflows is $26,675, the company should be willing to pay up to this amount to acquire the machine.
c. Investment required + Net annual cash flow = Factor of the internal rate of return
$30,000 + $6,000 = 5.000
To the nearest whole percent, the internal rate of return is 15%.
The machine should be purchased, since the internal rate of return is greater than the required rate of return.