Q24E - Horngren'S Financial And Managerial Accounting

Question

Using NPV to make capital investment decisions Holmes Industries is deciding whether to automate one phase of its production process. The manufacturing equipment has a six-year life and will cost \(910,000. 

Year 1     \) 262,000 Year 2       254,000 Year 3       222,000 Year 4      215,000 Year 5       200,000 Year 6       175,000

 

Requirements 

1. Compute this project’s NPV using Holmes’s 14% hurdle rate. Should Holmes invest in the equipment?

Holmes could refurbish the equipment at the end of six years for \(104,000. The refurbished equipment could be used one more year, providing \)77,000 of net cash inflows in year 7. Additionally, the refurbished equipment would have a $55,000 residual value at the end of year 7. Should Holmes invest in the equipment and refurbish it after six years? (Hint: In addition to your answer to Requirement 1, discount the additional cash outflow and inflows back to the present value.)

Step-by-Step Solution

Answer

1. NPV = $(24,170)
2. NPV = $(18,794)

Step 1: Meaning of Net Present Value (NPV)

The approach to deciding project reasonability is called net present value (NPV). This approach decides the display value of cash inflows and outflows sometime recently, calculating the investment's net present value. On the off chance that a project's NPV is positive, it ought to be affirmed.

Step 2: Computing NPV for the project

Years	Cash Flows	PVF (14%)	PV
	CF	PVF	CF PVF
Year 0	$(910,000)	1.000	$(910,000)
Year 1	$262,000	0.877	$229,774
Year 2	$254,000	0.769	$195,326
Year 3	$222,000	0.675	$149,850
Year 4	$215,000	0.592	$127,280
Year 5	$200,000	0.519	$103,800
Year 6	$175,000	0.456	$79,800
		NPV	$(24,170)

Note: The project's net present value (NPV) is negative, hence no investment should be made in it.

Step 3: Calculation of NPV

Years	Cash Flow	Refurbishment Cash Flow	Total Cash Flows	PVF (14%)	PV
	CF	RCF	TCF=CF+RCF	PVF	TCF PVF
Year 0	$(910,000)		$(910,000)	1.000	$(910,000)
Year 1	$262,000		$262,000	0.877	$229,774
Year 2	$254,000		$254,000	0.769	$195,326
Year 3	$222,000		$222,000	0.675	$149,850
Year 4	$215,000		$215,000	0.592	$127,280
Year 5	$200,000		$200,000	0.519	$103,800
Year 6	$175,000	$(104,000)	$71,000	0.456	$32,376
Year 7	$77,000	$55,000	$132,000	0.400	$52,800
				NPV	$(18,794)

Even with the renovation option, the project's NPV is negative; hence, no investment should be made in the project.