Capital budgeting using the NPV method
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EnterTech has noticed a significant decrease in the profitability of its line of portable CD players.
The production manager believes that the source of the trouble is old, inefficient equipment used
to manufacture the product. The issue raised, therefore, is whether EnterTech should (1) buy new
equipment at a cost of $120,000 or (2) continue using its present equipment.
It is unlikely that demand for these portable CD players will extend beyond a five-year time
horizon. EnterTech estimates that both the new equipment and the present equipment will have a
remaining useful life of five years and no salvage value.
The new equipment is expected to produce annual cash savings in manufacturing costs of
$34,000, before taking into consideration depreciation and taxes. However, management does not
believe that the use of new equipment will have any effect on sales volume. Thus, its decision rests
entirely on the magnitude of the potential cost savings.
The old equipment has a book value of $100,000. However, it can be sold for only $20,000 if it
is replaced. EnterTech has an average tax rate of 40 percent and uses straight-line depreciation for
tax purposes. The company requires a minimum return of 12 percent on all investments in plant
assets.
a. Compute the net present value of the new machine using the tables in Exhibits 26-3
and 26-4.
b. What nonfinancial factors should EnterTech consider?
c. If the manager of EnterTech is uncertain about the accuracy of the cost savings estimate, what
actions could be taken to double-check the estimate?
Exhibit 26-3
Present Value of $1 Due in n Periods *
Number of
Periods
( n )
Discount Rate
1% 1½% 5% 6% 8% 10% 12% 15% 20%
1 .990 .985 .952 .943 .926 .909 .893 .870 .833
2 .980 .971 .907 .890 .857 .826 .797 .756 .694
3 .971 .956 .864 .840 .794 .751 .712 .658 .579
4 .961 .942 .823 .792 .735 .683 .636 .572 .482
5 .951 .928 .784 .747 .681 .621 .567 .497 .402
6 .942 .915 .746 .705 .630 .564 .507 .432 .335
7 .933 .901 .711 .665 .583 .513 .452 .376 .279
8 .923 .888 .677 .627 .540 .467 .404 .327 .233
9 .914 .875 .645 .592 .500 .424 .361 .284 .194
10 .905 .862 .614 .558 .463 .386 .322 .247 .162
20 .820 .742 .377 .312 .215 .149 .104 .061 .026
24 .788 .700 .310 .247 .158 .102 .066 .035 .013
36 .699 .585 .173 .123 .063 .032 .017 .007 .001
Exhibit 26-4
Present Value of $1 to Be Received Periodically for n Periods
Number of
Periods
( n )
Discount Rate
1% 1½% 5% 6% 8% 10% 12% 15% 20%
1 0.990 0.985 0.952 0.943 0.926 0.909 0.893 0.870 0.833
2 1.970 1.956 1.859 1.833 1.783 1.736 1.690 1.626 1.528
3 2.941 2.912 2.723 2.673 2.577 2.487 2.402 2.283 2.106
4 3.902 3.854 3.546 3.465 3.312 3.170 3.037 2.855 2.589
5 4.853 4.783 4.329 4.212 3.993 3.791 3.605 3.352 2.991
6 5.795 5.697 5.076 4.917 4.623 4.355 4.111 3.784 3.326
7 6.728 6.598 5.786 5.582 5.206 4.868 4.564 4.160 3.605
8 7.652 7.486 6.463 6.210 5.747 5.335 4.968 4.487 3.837
9 8.566 8.361 7.108 6.802 6.247 5.759 5.328 4.772 4.031
10 9.471 9.222 7.722 7.360 6.710 6.145 5.650 5.019 4.192
20 18.046 17.169 12.462 11.470 9.818 8.514 7.469 6.259 4.870
24 21.243 20.030 13.799 12.550 10.529 8.985 7.784 6.434 4.937
36 30.108 27.661 16.547 14.621 11.717 9.677 8.192 6.623 4.993
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Solution Summary
Net present value ( NPV) is one of capital budgeting techniques. Its advantage over other techniques is that it takes into account the time value of money. A project is only viable or acceptable when the computed NPV is positive because it indicates that the net future cash flows, discounted to the present, exceed the initial investment. The validity of the result, however, is affected by nonfinancial factors such as the orientation and assumptions as to possible future conditions of the financial analyst. This issue may be addressed through the use of other experts or the use of Expert Opinion Method.
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CAPITAL BUDGETING USING THE NET PRESENT VALUE METHOD
Net present value is equal to initial cash outflow less the sum of discounted cash inflows. Higher net present value is preferred and an investment is only viable if its NPV is positive. NPV is a capital budgeting technique that takes into account the time value of money.
As applied to the problem at hand:
Given:
New Equipment Present equipment
Initial outlay ...
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- Bachelor of Science in Business Administration, University of the Philippines
- Master in Business Administration, Saint Mary's University
- Doctor of Philosophy in Education, University of the Philippines
- Doctor in Business Adminstration (IP), Polytechnic University of the Philippines
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