Question

OptiLux is considering investing in an automated manufacturing system. The system requires an initial investment of $4 million, has a 20-year life, and will have zero salvage value. If the system is implemented, the company will save $500,000 per year in direct labor costs. The company requires a 10% return from its investments. 1. Compute the proposed investment’s net present value. 2. Using your answer from part 1, is the investment’s internal rate of return higher or lower than 10%?

Answer 1

Answer:

Requirement 1: $257,000 Positive

Requirement 2: IRR is higher than 10%

Explanation:

Requirement 1:

We can use the following formula, to calculate the net present value of the project:

Net Present Value = Annual Cash Inflows * Annuity Factor - Investment

Here

Annual Cash Inflow is $500,000

r is 10%

n is the life of the project which is 20 years

Annuity factor = (1- (1+r)^-n)  / r   =  (1 - (1 + 10%)^-20) / 10%  = 8.514

Investment is $4,000,000

By putting values in the above equation, we have:

Net Present Value = $500,000 * 8.514 - $4,000,000

NPV = $257,000 Positive

Requirement 2:

Internal rate of return gives the required rate at which NPV is zero.

Since NPV is positive at 10%, IRR will be higher than 10%.

Always remember that, increase in the discount rate decreases the NPV and vice versa.