Question

Newton Inc. is evaluating the purchase of a new machine. The cost of the machine is $800,000. The incremental cash flows due to the machine are expected to be as follows:

Year 1              $150,000

Year 2              $250,000

Year 3              $350,000

Year 4              $480,000

The cost of capital for Newton, Inc. is 11%.

1. Calculate the NPV and IRR for this project.

2. Should you accept this project? Explain. Mention both NPV and IRR in your explanation.

3. At what costs of capital will this project be unacceptable, based on the NPV method.

4.Calculate the profitability index (PI) for this project. .

5.Should this project be accepted based on the PI? Explain.

Answer 1

1.

NPV = -800,000 + 150,000/(1.11) + 250,000/(1.11)2 + 350,000/(1.11)3 + 480,000/(1.11)4

NPV = $110,148.59

Calculating IRR,

800,000 = 150,000/(1 + IRR) + 250,000/(1 + IRR)2 + 350,000/(1 + IRR)3 + 480,000/(1 + IRR)4

IRR = 16.23%

2.

One should accept the project as NPV is positive

3.

At cost of capital > 16.23%, as NPV will be zero or negative,