2.7. Peoria Corporation is planning to acquire a machine at a cost of $125,000.

ID: 2779173 • Letter: 2

Question

2.7. Peoria Corporation is planning to acquire a machine at a cost of $125,000. The following table shows the expected life of the machine.

Probability

Expected life

4 years

10%

5 years

85%

6 years

The company will depreciate the machine on a straight-line basis with a life of 5 years, with no residual value. While the machine is in operation, it will generate a pretax income of $35,000 annually. The tax rate of Company is 30% and it uses a discount rate of 12%. Should Peoria buy the new machine? No answer is given.

Probability

Expected life

4 years

10%

5 years

85%

6 years

Explanation / Answer

WN-1

Expected Life of Machine

Probability

Expected Life

(Probability ) X ( Expected Life )

5 %

4 Years

0.20

10 %

5 Years

0.50

85 %

6 Years

5.10

5. 80 Years

NPV of Project –

NPV = Present Value of Cash Inflow – Cash Outflow

Annual Pre Tax Cash Flow

35,000

After Tax Cash Flow

24,500 ( 35000 x70 %)

Add Depreciation

25,000 (125,000/5)

Net Cash Flow Annual

49,500

PV Factor @ 12 % for 5 Years

3.605

Present Value of Cash Inflow

178,448

NPV = 178448-125000

NPV = $ 53,448

If project life is considered it will show a positive NPV, but e3xpected life of project is 5.80 years hence it will generate more NPV compare to 5 year NPV.

Hence Peoria Corporation should buy this new machine.