Example of NPV Method
Resolution limited intends to purchase a machine worth Shs.1, 500,000 that will have a residue value Shs.200,000 after 5 years helpful life. The saving in cost resulting from the utilize of this machine are as:
Shs.
Year 1 800,000
Year 2 350,000
Year 3 -
Year 4 680,000
Year 5 775,000
By using NPV method, inform the company where this machine should be purchased whether the cut off rate is 14 percent and acceptable saving in cost is 12 percent of the cost of the investment.
Solution
|
Year
|
1
|
2
|
3
|
4
|
5
|
|
Saving
Scrap value
Total amount
|
800,000
-
800,000
|
350,000
-
350,000
|
-
-
-
|
680,000
-
680,000
|
775,000
200,000
975,000
|
NPV = 800,000 / (1.14) + 350,000 / (1.14)2 + 680,000 / (1.14)4 +975,000 / (1.14)5 - 1,500,000
= 1,880,067.1 - 1,500,000
= 380,067.07
Return = (380,067.0/1,500,000) * 100
= 25.337% > 12% therefore invest.
NB: By assuming that the salvage will be realized.