A new operating system for an existing maching is expected to cost $786000 and have a useful life of six years. The system yields an incremental after-tax income of $230000 each year after deducting its straight line depreciation. The predicted salvage value of the system is $90000. Assume the company requires a 10% rate of return on its investments. Compute the net present value of each potential investment.

NPV is $771,739

Explanation:

As we know that:

Net Present Value = Present Value of Cash inflow (STEP 1) - Present Value of Cash outflow

STEP 1. Present Value of Cash Inflow

Here

Present Value of Cash Inflow = Annuity of Annual Cash flow    - PV of Scrap Value

Annual Cash flow is $346,000 ($230,000  +   ($786,000 - $90,000)/6)

So

Annuity of annual cash inflow = $346,000 * Annuity Factor

Here

Annuity Factor for 6 years is 4.3553

Now this means that:

Annuity of annual cash Inflow = $346,000 *  4.3553 = $1,506,934

Present Value of Residual Value ($90,000 * 0.5645) = $50,805

Present Value of cash inflows                                        $1,557,739

Now putting values in the above equation, we have:

Net Present Value = $1,557,739   -    $786,000

Net Present Value = $771,739

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