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

Exercise 57

Calculate NPV, present value ratio, and payback TopCap Co. is evaluating the purchase of another sewing machine that will be used to manufacture sport caps. The invoice price of the machine is $208,000. In addition, delivery and installation costs will total $10,000. The machine has the capacity to produce 18,000 dozen caps per year. Sales are forecast to increase gradually, and production volumes for each of the five years of the machine’s life are expected to be:

2010	5,400 dozen
2011	8,400 dozen
2012	12,750 dozen
2013	13,950 dozen
2014	18,000 dozen

The caps have a contribution margin of $6.00 per dozen. Fixed costs associated with the additional production (other than depreciation expense) will be negligible. Salvage value and the investment in working capital should be ignored. TopCap Co.’s cost of capital for this capacity expansion has been set at 14%.

Required:

a. Calculate the net present value of the proposed investment in the new sewing machine.

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b. Calculate the present value ratio of the investment.

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c. What is the internal rate of return of this investment relative to the cost of capital?

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d. Calculate the payback period of the investment.

Step 1 of 6

NPV, present value ratio, internal rate of return, and payback period

Net present value (NPV ): NPV is the distinction in terms of present value between the cash inflows and cash outflows.

Present value ratio : It shows the present value of inflows in proportion to the present value of investment or cash outflows.

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 in comparing an investment with another.

Payback period : The duration of time essential to recover the investment cost of a specified portfolio.