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2015 Sep no 3

Discussion in 'CB1' started by Robert, Sep 6, 2019.

  1. Robert

    Robert Very Active Member

    An investment opportunity involves the purchase of a machine for $40,000. The machine will have a useful life of five years, after which time it will be scrapped. The machine will increase reported profit by $11,000 every year for five years. The company uses straight line depreciation. The required rate of return is 8% per annum. The investment will be funded by a loan for five years with an interest rate of 6% per annum.
    Calculate the net present value of this investment.

    Can I know how would you calculate this question?
     
    Robert, Sep 6, 2019
    #1
  2. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Lynn Birchall, Sep 6, 2019
    #2
  3. Josh Strange

    Josh Strange Made first post

    Do you mind explaining why -40,00 + 19000v1 + 19000v2 + ... 19000v5 doesnt return the right answer for the NPV?
     
    Josh Strange, Feb 28, 2022
    #3
  4. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Hi Josh

    It should do! Just need to make sure you do the discounting at the required rate of return (8%) (not the 6% cost of the loan).

    Hope that works
    Lynn
     
    Lynn Birchall, Mar 1, 2022
    #4
  5. Josh Strange

    Josh Strange Made first post

    Yeah was just being silly! - Can I ask why the 6% is ignored?
     
    Josh Strange, Mar 1, 2022
    #5
  6. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Glad that's sorted easily :)

    It's because in NPV we want to discount at a rate that reflects the riskiness of the project. The 6% cost of the loan finance isn't telling us this because it will also depend on a number of other factors, eg lenders will have based that 6% on the existing other activities of the company too and the company's existing use of finance.
     
    Lynn Birchall, Mar 1, 2022
    #6
  7. Han

    Han Keen member

    Hi Lynn,
    Couple of questions regarding this question:

    1. From the other post and above, it seems that profit = cashflow - depreciation. What if, for example, we were told that there was a maintenance cost or some sort of tax/fee that cost $2000 annually for the machine, would we add this back to the profit as well?

    2. Slightly confused about why the 40k is paid at time 0 when we are told that it is funded by a loan for 5 years. Why is it not 40/(1.06)^5 instead at time 5? Since its funded by a loan, the cashflow that the company has to fork out at time 0 would be 0 but 40/(1.06)^5 at time 5 since thats the amount it pays the lender?

    Thanks!
     
    Han, Mar 2, 2022
    #7
  8. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Hi Han

    1. We add the depreciation back to the profit because it is not an actual cashflow, and it is the cashflows we want to discount in an NPV calculation. Any maintenance costs, fess, taxes sound as though they are actual cashflows, so there would be no need to add these back.

    2. We completely separate out the cashflows from the project from the cashflows associated with the financing of the project. The company really would have paid 40k at time 0 to the seller of the machine - so we include this. The company would also have recieived 40k at time 0 from the provider of the loan - but we're not including the financing in an NPV.

    Lynn
     
    Lynn Birchall, Mar 2, 2022
    #8

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