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The management of Penfold Corporation is considering the purchase of a machine that would cost...

Question:

The management of Penfold Corporation is considering the purchase of a machine that would cost $300,000, would last for 5 years, and would have no salvage value. The machine would reduce labor and other costs by $70,000 per year. The company requires a minimum pretax return of 12% on all investment projects.

Calculate the net present value of the proposed project (ignore income taxes).

Net Present Value Method:

For a given firm, the net present value method yields the change in the wealth of investors if a given project is undertaken by the firm. It is usually preferred over other methods such as internal rate of return method, profitability index method, cash payback period method etc. for mutually exclusive projects.

Answer and Explanation:

The calculated net present value of the proposed project is -$47,666.

The net present value of the project can be calculated by subtracting the initial purchasing cost from the sum of present values of all expected annual cost savings where the discount factor consists of required rate of return of 12% (0.12) and its exponential power denotes the timing of the respective cash flow as shown below:

Net present value:

  • {eq}= \dfrac{\$70,000}{1.12^1} + \dfrac{\$70,000}{1.12^2} + ....+ \dfrac{\$70,000}{1.12^5} - $300,000 {/eq}
  • = -$47,666

Learn more about this topic:

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How to Calculate Net Present Value: Definition, Formula & Analysis

from Financial Accounting: Help and Review

Chapter 5 / Lesson 20
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