Wanda owns a company selling inflatable unicorn horns for cats. Wanda is expandi

Question

Wanda owns a company selling inflatable unicorn horns for cats. Wanda is expanding by buying an additional machine to make inflatable unicorn horns that costs $62,000, has a zero terminal disposal value, and has a 10-year useful life. It expects the annual increase in cash revenues from the expansion to be $28,000 more per year. It further expects additional annual cash costs to be $18,000 per year. Its cost of capital is 8%. The tax rate is 35%.

Required:

a) a) Calculate the NPV.

b) b) Later, Wanda

Explanation / Answer

Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts fortime value of money by using discounted cash inflows.

Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.

The first step involved in the calculation of NPV is the determination of the present value of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods). When they are even, present value can be easily calculated by using the present value formula of annuity. However, if they are uneven, we need to calculate the present value of each individual net cash inflow separately.

In the second step we subtract the initial investment on the project from the total present value of inflows to arrive at net present value.

Thus we have the following two formulas for the calculation of NPV:

When cash inflows are even:

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