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The Terme Corporation is contemplating the purchase of new equipment, which may potentially...

Question:

The Terme Corporation is contemplating the purchase of new equipment, which may potentially increase revenues by 35%. Currently, sales are $680,000 per year and cost of sales are 65% of sales. The equipment is expected to last for 4 years with no residual value. The cash outflow expected at the beginning of the year is $283,200. By how much would Terme's annual gross profit increase if the investment is undertaken?

NPV

NPV or net present value is a measure used in capital budgeting for evaluating long term projects involving considerable investments it considers the effect of time value of money for the cashflows standing at different points in time.

Answer and Explanation:

Since, Annual increase in the revenue = 35% of $680000 = $238000

Therefore, Annual increase in profits = $238000 * (1- cost%) = $238000 * (1-65%) = $83300

To assess whether investment should be undertaken or not ,we need to find the NPV of the investment, since required return is not given in the question let us assume it to be =10%

Therefore

NPV = PV of annual cash benefits - initial outflow

PV = {eq}\frac{E(1-(1+r)^-p)}{r} {/eq}

Where

E = annual benifits = %83300

r = monthly interest rate = 10%

p = years = 4 years

Therefore

PV = {eq}\frac{83300(1-1.10^{-4})}{.10 } {/eq}

PV = $264050

NPV = $264050 -$283200 = -$19150

Since, NPV is negative it can be said that at 10% required return, this investment is not viable.


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Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
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