example of npv methodresolution limited intends

Question

Example of NPV Method

Resolution limited intends to purchase a machine worth Shs.1, 500,000 that will have a residue value Shs.200,000 after 5 years helpful life. The saving in cost resulting from the utilize of this machine are as:

                                                Shs.

                   Year 1                  800,000

                   Year 2                  350,000

                   Year 3                       -

                   Year 4                  680,000

                   Year 5                  775,000

By using NPV method, inform the company where this machine should be purchased whether the cut off rate is 14 percent and acceptable saving in cost is 12 percent of the cost of the investment.

Solution

Year	1	2	3	4	5
Saving Scrap value Total amount	800,000           - 800,000	350,000           - 350,000	-        - -	680,000           - 680,000	775,000 200,000 975,000

NPV = 800,000 / (1.14) + 350,000 / (1.14)² + 680,000 / (1.14)⁴ +975,000 / (1.14)⁵ - 1,500,000

= 1,880,067.1 - 1,500,000

= 380,067.07

Return        = (380,067.0/1,500,000) * 100         

                   = 25.337% > 12% therefore invest.

NB: By assuming that the salvage will be realized.