Net Present Value Analysis. Architect Services, Inc., would like to purchase a blueprint machine for $50,000. The machine is expected to have a life of 4 years, and a salvage value of $10,000. Annual maintenance costs will total $14,000. Annual savings are predicted to be $30,000. The company’s required rate of return is 11 percent. Required: a. Ignoring the time value of money, calculate the net cash inflow or outflow resulting from this investment opportunity. b. Find the net present value of this investment using the format presented in Figure 8.2. c. Should the company purchase the blueprint machine? Explain.
Architect Services, Inc. is considering purchasing a blueprint machine for $50,000. This machine has a 4-year lifespan, with a salvage value of $10,000. The annual maintenance costs are $14,000, but it’s expected to save the company $30,000 each year. The company’s required rate of return is 11 percent. We’ll analyze this investment in three parts:
I. Without Considering Time Value
II. Calculating the Net Present Value (NPV)
III. Making the Investment Decision
I. Without Considering Time Value: Ignoring the time value of money, the initial investment is $50,000. Inflow includes annual savings of $30,000 and a salvage value of $10,000. Outflow consists of annual maintenance costs, totaling $56,000 over four years. The net cash flow without considering time value is -$66,000.
II. Calculating the Net Present Value (NPV): Considering the time value of money, we calculate the NPV. Year 1 has a cash flow of $16,000, discounted to $14,414.41. Year 2 and Year 3 follow the same pattern, with discounted cash flows of $12,977.39 and $11,686.16, respectively. Year 4’s discounted cash flow is $8,600.74. The total NPV is -$2,321.30.
III. Making the Investment Decision: The negative NPV of -$2,321.30 suggests that the blueprint machine investment is not financially viable, considering the time value of money. Architect Services, Inc. should reconsider purchasing the machine.
In summary, the NPV analysis provides a clear financial basis for decision-making. Architect Services should be cautious about this investment, as it’s projected to yield less than the initial cost, factoring in the time value of money.
Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance. McGraw-Hill Education.
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2018). Essentials of Corporate Finance. McGraw-Hill Education.
Smart, S. B., & Megginson, W. L. (2019). Introduction to Corporate Finance. Cengage Learning.
Frequently Asked Questions (FAQs)
What is Net Present Value (NPV) analysis, and why is it important for Architect Services, Inc.?
NPV analysis is a financial tool used to assess the viability of investments. For Architect Services, it’s crucial to determine if the blueprint machine purchase is a wise financial decision. The NPV helps by considering the time value of money, providing insights into the investment’s true value.
How is the time value of money factored into the analysis?
Time value of money accounts for the idea that a dollar received today is worth more than a dollar received in the future. In our analysis, we discount future cash flows back to their present value using the company’s required rate of return (11 percent). This reflects the opportunity cost of the invested capital.
What does the negative NPV of -$2,321.30 mean for Architect Services?
A negative NPV implies that the investment in the blueprint machine is expected to yield less value than the initial cost, considering the time value of money. Architect Services should be cautious about proceeding with the purchase as it may not be financially viable.
Why did we calculate the net cash inflow without considering the time value of money?
This calculation provides a simple overview of the investment’s cash flows, treating each dollar as equal, regardless of when it is received or paid. It’s a basic way to assess the investment’s potential without considering the nuances of the time value of money.
What factors are considered in the NPV analysis besides the initial investment and cash flows?
In the NPV analysis, we also account for the salvage value of the blueprint machine and the annual maintenance costs. These factors play a crucial role in determining the true financial impact of the investment over its lifespan.