Question

1. A new operating system for an existing machine is expected to cost $820,000 and have a useful life of six years. The system yields an incremental after-tax income of $240,000 each year after deducting its straight-line depreciation. The predicted salvage value of the system is $100,000.
2. A machine costs $560,000, has a $56,000 salvage value, is expected to last eight years, and will generate an after-tax income of $150,000 per year after straight-line depreciation.

Assume the company requires a 12% rate of return on its investments. Compute the net present value of each potential investment. (PV of $1, FV of $1, PVA of $1, and FVA of $1) (Use appropriate factor(s) from the tables provided.)

Answer 1

Calculation of net present value
a) annual cash flow
incremental after tax income			240000
add: depreciation(820000-100000)/6			120000
annual cash flow			360000
cash flow		amount	pvf@ 12%	present value
annual cash flow		360000	4.1114	1480104
residual value		100000	0.5066	50660
Present value of cashflow				1530764
less: cash expected cost				820000
Net present value				710764
b) annual cash flow
after tax income			150000
add: depreciation (560000-56000)/8			63000
annual cash flow			213000
cash flow		amount	pvf@ 12%	present value
annual cash flow		213000	4.9676	1058099
residual value		56000	0.4039	22618.4
Present value of cashflow				1080717
less: cash expected cost				560000
Net present value				520717

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