Question

Dobson Contractors is considering buying equipment at a cost of $75,000. The equipment is expected to generate cash flows of $15,000 per year for eight years and can be sold at the end of eight years for $5,000. Interest is at 12%. Assume the equipment would be paid for on the first day of year one, but that all other cash flows occur at the end of the year. Ignore income tax considerations. Determine the net present value of the cash flows and if Dobson should purchase the machine.a. $194,256 negative net present value of the cash flows. Based on present value considerations, Dobson Construction should not buy the machine.b. $194,256 positive net present value of the cash flows. Based on present value considerations, Dobson Construction should buy the machine.c. $1,534 negative net present value of the cash flows. Based on present value considerations, Dobson Construction should not buy the machine.d. $1,534 positive net present value of the cash flows. Based on present value considerations, Dobson Construction should buy the machine.

Answer 1

Answer: d. $1,534 positive net present value of the cash flows. Based on present value considerations, Dobson Construction should buy the machine.

Explanation:

To calculate the Net Present Value, we take the present values of all the future cashflows and subtract the initial cost from this amount.

Now, the cashflows are stable and this means that we can use the Present Value of an Annuity factor to find out the present value of the cashflows. We can then use a simple present value formula to find out the PV of the sale price.

I have attached a table that shows the PVIFA factors to make our calculations easier.

With interest rates at 12% and the year being 8 years, the PVIFA factors is 4.9676

Calculating therefore we have,

= 15,000 * 4.9676

= $74,514

This is the present value of 8 years of $15,000 cash flows.

In the same year, the machine can be sold for $5,000 so the present value of that is,

= 5000 / ( 1 + 12%)^8

= $2,020

Adding those together we get,

= 74,514 + 2,020

= 76,534

= $76,534

Subtracting the original cost we have,

= 76,534 - 75,000

= $1,534 in positive cashflow.

Net Present Value = $1,534

This means that Based on present value considerations, Dobson Construction should buy the machine due to a $1,534 positive net present value.