Question

The company is considering a project involving a purchase of new equipment. Change the data area of your worksheet to match the following:

Cost of new equipment needed: $370,000

Working capital needed: $45,000

Overhaul of equipment in four years: $30,000

Salvage value of equipment in five years: $25,000

Annual revenues and costs:

Sales revenues: $430,000

Cost of goods sold: $250,000

Out-of-pocket operating costs: $70,000

Discount rate: 15%

1. What is the net present value of the project?

2. The internal rate of return is between what two whole discount rates?

3. Reset the discount rate to 15%. Suppose the salvage value is uncertain. How large would the salvage value have to be to result in a positive net present value?

Answer 1

1. NPV of the project

Year	0	1	2	3	4	5
Cost of equipment	-370000
Working capital	-45000
Overhaul of equipment					-30000
Salvage Value						25000
Release of working capital						45000
Annual cash inflows		110000	110000	110000	110000	110000
Net cash flows	-415000	110000	110000	110000	80000	180000
PV @ 15%	1	0.870	0.756	0.658	0.572	0.497
Present Value	-415000	95652	83176	72327	45740	89492
Net Present Value						-28613

2. Calculation of IRR

At IRR, NPV = 0

0 = -415000 + 110000/ (1 + IRR) + 110000/ (1 + IRR)^2 + 110000/ (1 + IRR)^3 + 80000/ (1 + IRR)^4 + 180000/ (1 + IRR)^5

IRR = 12.20%

3. Suppose the salvage value is uncertain. How large would the salvage value have to be to result in a positive net present value

Calculation of NPV without salvage value:

Year	0	1	2	3	4	5
Cost of equipment	-370000
Working capital	-45000
Overhaul of equipment					-30000
Release of working capital						45000
Annual cash inflows		110000	110000	110000	110000	110000
Net cash flows	-415000	110000	110000	110000	80000	155000
PV @ 15%	1	0.870	0.756	0.658	0.572	0.497
Present Value	-415000	95652	83176	72327	45740	77062
Net Present Value						-41043

For NPV to be positive the Present Value of salvage should be greater or equal to NPV i.e $41,043

PV of salvage = Salvage Value * PV (15%, 5 year)

41,043 = Salvage Value * 0.497

Salvage Value = 41,043 / 0.497 = $ 82,551