Question

Stop Slicing Inc. is evaluating the purchase of a new computer system. System A will require an initial outlay of $100,000. Cash inflows are expected to be $10,000 at the end of year one, $20,000 at the end of year two, $30,000 at the end of year three, $30,000 at the end of year four, and $50,000 at the end of year five. System B will require an initial outlay of $50,000, with expected cash inflows of $10,000 at the end of year one, $20,000 at the end of year two, $15,000 at the end of year three, and $15,000 at the end of year four. The firm has a 10% required rate of return (the "hurdle rate"). Based upon net present value, and assuming only one system is needed, which computer system should SSI acquire?

Select one:

A. System A.

B. System B.

C. Neither System A nor System B.

D. Cannot be determined from the information provided.

Answer 1

The net present value is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

The NPV of System A is computed as follows:

= - $ 100,000 + $ 10,000 / 1.10¹ + $ 20,000 / 1.10² + $ 30,000 / 1.10³ + $ 30,000 / 1.10⁴ + $ 50,000 / 1.10⁵

= - $ 304.25 Approximately

The NPV of System B is computed as follows:

= - $ 50,000 + $ 10,000 / 1.10¹ + $ 20,000 / 1.10² + $ 15,000 / 1.10³ + $ 15,000 / 1.10⁴

= - $ 2,865.24 Approximately

Since the NPV of both of the systems is negative, hence we shall not accept any of these systems.

So, the correct answer is option C. i.e. Neither System A nor System B.

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