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Q24E

Expert-verified
Horngren'S Financial And Managerial Accounting
Found in: Page 1469

Short Answer

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.)

  1. NPV = $(24,170)
  2. NPV = $(18,794)
See the step by step solution

Step by Step Solution

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.

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