Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 39

Calculate NPV—compare to IRR South Bay Manufacturing Ltd. is considering the investment of $230,000 in a new machine. The machine will generate cash flow of $40,000 per year for each year of its eight-year life and will have a salvage value of $26,000 at the end of its life. The company’s cost of capital is 10%.

Required:

a. Calculate the net present value of the proposed investment. (Ignore income taxes.)

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b. What will the internal rate of return on this investment be relative to the cost of capital? Explain your answer.

Step 1 of 3

Net present value (NPV):

• It is one of the discounted cash flow techniques. This method involves discounting net cash flow to their present value and then matching that present value with the capital expenditure required by the investment. The difference between these two amounts is net present value.

• Simply net Present Value is difference between the present value of cash inflows and initial investment.

Internal rate of return (IRR):

It refers to the interest rate that makes the summation of all cash inflows and outflows zero, and is helpful to compare an investment to another.