Newman Labs is considering buying equipment, which would enable the company to obtain a five-year research contract. The specialized equipment costs $650,000 and will have no salvage value when the five-year contract period is over. The estimated annual operating results of the project are as follows:

revenue 750,000expenses (including straight line depreciation) 650,000increase in net income 100,000All revenue from the contract and all expenses (except depreciation) will be received or paid in cash in the same period as recognized for accounting purposes. Refer to the information above. Compute the net present value of this investment, using a discount rate of 12%. (An annuity table shows that the present value of $1 received annually for five years, discounted at 12%, is 3.605.)a. $468,650. b. $179,150. c. $289,500. d. $829,150.

B

Explanation:

Net present value is a tool used to analyze how profitable a project by deducting the present value the difference between cash inflow and cash outflow over a period of time.

The formula is (cash flow)/(1+r)^i

Revenue - $750,000

Expenses - $650,000

Increase in net income - 100,000

Annual depreciation charge - 650000/5 =$130,000

Discount rate - 12%=3.605

Present cash value =( $100,000+$130000) = $230,000

Please note that depreciation is added back as it is a non cash expenses

Present value of cash flow = annual cash flow * discount rate

=$230,000*3.605 =829,150

Net present value = 829150-650000= 179,150

Option B. $179,150 NPV  

Explanation:

In this case, there is no taxes which means we will have to ignore the tax implications.

Now, as we know that NPV can be calculated as under:

NPV = Annual Net Cash flow (Step 1) * Annuity Factor - Initial Investment

Here

Initial investment is $650,000

Annuity Factor at 12% is 3.605

Annual Net Cash Flow is $230,000 (Step 1)

So by putting values we have:

NPV = $230,000 * 3.605 - $650,000

NPV = $829,150 - $650,000 = $179,150 NPV

Step 1. Annual Net Cash flow

Here Annual Net cash flow can be calculated as under:

Annual Net Cash Flow = Cash Inflow - Cash Outflow (Step 2)

Cash inflow $750,000

Cash Outflow is $520,000

Which means

Annual Net Cash Flow = $750,000 - $520,000 = $230,000

Step 2. Cash Outflow

Cash outflow is not given but we can find it using the expense $650,000 and eliminating the non cash impact of the expenses included (Depreciation). So we will have to find the depreciation using the straight line basis and deduct it from the aggregated expense for the year to find cash outflow for the year.

Depreciation for the year = (Cost - Salvage Value) / Useful

Depreciation for the year = $650,000 / 5 = $130,000

So the yearly cash outflow is:

Annual Cash Outflow = $650,000 - 130,000 = $520,000

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