Copyright

Your firm has the option of making an investment in new software that will cost $130,000 today...

Question:

Your firm has the option of making an investment in new software that will cost $130,000 today and is estimated to provide the savings as shown in the following table over its five-year life

Year Savings estimate
1 $35,000
2 $50,000
3 $45,000
4 $25,000
5 $15,000

Should the firm make this investment if it requires a minimum annual return of 9% on all investments?

Project Selection Criteria:

There are a number of project selection rules. These include the Internal rate of return (IRR), the modified Internal rate of return (MIRR), the accounting rate of return (ARR), the payback period, the discounted payback period, and others. The most popular selection rule, however is the net present value (NPV).

Answer and Explanation:

We will use the net present value (NPV) decision rule to decide if this project is worth pursuing.

Let,

  • I = initial investment
  • CF = subsequent cash flows
  • r = cost of capital
  • n = number of periods

The NPV can be found using the formula:

{eq}NPV=-I+\sum_{i=1}^{n}\frac{CF_{i}}{(1+r)^{i}}\\ NPV=-I+\frac{CF_{1}}{(1+r)^1}+\frac{CF_{2}}{(1+r)^2}+\frac{CF_{3}}{(1+r)^3}+\frac{CF_{4}}{(1+r)^4}+\frac{CF_{5}}{(1+r)^5}\\ NPV=-130,000+\frac{35,000}{(1+0.09)^1}+\frac{50,000}{(1+0.09)^2}+\frac{45,000}{(1+0.09)^3}+\frac{25,000}{(1+0.09)^4}+\frac{15,000}{(1+0.09)^5}\\ NPV=\$6,401.95\\ {/eq}

Because the NPV calculated above is positive, the firm should take this investment.


Learn more about this topic:

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

from Financial Accounting: Help and Review

Chapter 5 / Lesson 20
11K

Related to this Question

Explore our homework questions and answer library