Exercise 11-2 Net Present Value Method [LO11-2] The management of Kunkel Company

Question

Exercise 11-2 Net Present Value Method [LO11-2] The management of Kunkel Company is considering the purchase of a $21,000 machine that would reduce operating costs by $5,000 per year. At the end of the machine's five-year useful life, it will have zero scrap value. The company's required rate of return is 12%. Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables Required: 1. Determine the net present value of the investment in the machine. Net present value 2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the machine? (Any cash outflows should be indicated by a minus sign.) Total Cash Flows Cash Flow Years Annual cost savings Initial investment [ Net cash flow

Explanation / Answer

1) Net Present Value = Present Value of Annual Cost savings - Initial Investment

= [Annual Operating cost savings*PVAF(12%, 5 yrs)] - Purchase Cost of Machine

= ($5,000*3.60478) - $21,000

= $18,024 - $21,000 = ($2,976)

Therefore NPV is negative (i.e. -$2,976).

2)

Item Cash Flow (A) Years (B) Total Cash Flows (A*B) a) Annual Cost Savings $5,000 5 $25,000 b) Initial Investment $21,000 1 $21,000 Net Cash Flow (a - b) $4,000

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