Question

The management of Kunkel Company is considering the purchase of a $41,000 machine that would reduce operating costs by $9,000 per year. At the end of the machine’s five-year useful life, it will have zero salvage value. The company’s required rate of return is 12%.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using table.

Required:

1. Determine the net present value of the investment in the machine.

2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the machine?

Answer 1

1. Net Present Value of the Investment in the machine

By purchasing the machine there is reduction of $9,000 per year, which is nothing but a inflow to the Kunkel Company.

There is no salvage value so there is no Inflow at the end of Useful life of asset.

Net Present Value = Present Value of Future Cash inflows - Present Value of Future Cash outflows

Here, the Cash Outflows are $41,000 which is Initial Investment at year 0.

               Cash Inflows are $9,000 per year

Present Value of Future Cash Inflows = $9,000 * Present Value of annuity factor for 5 years at 12% discount rate

                                                      = $9,000 * 3.605

                                                      = $9,000 * 3.605

                                                      = $32,445

Net Present Value = Present Value of Future Cash inflows - Present Value of Future Cash outflows

                           = $32,445 - $41,000

                           = ($8,555)

The Net Present Value is negative. The advice is not to purchase the machine as there is more outflow of Cash than Inflows in Present Value terms.

2. Difference between Total undiscounted Cash inflows and Cash Outflows over entire life of machine

           Total Undiscounted Cash inflows = $9,000 per Year * 5 years

                                                            = $45,000

           Total Undiscounted Cash outflows = $41,000

                                   = Undiscounted cash inflows - Undiscounted Cash Outflows

                                   = $45,000 - $41,000

                                   = $4,000