Bacon Signs plans a major retooling of their manufacturing plant. The equipment has an initial capital cost of $5,000,000 but would increase operating cash flow by $1,500,000 each year for five years
The equipment could be sold for a net cash flow of $1,000,000 in five years. If the hurdle rate is 14%, and the permanent increase in working capital is $500,000, should the firm purchase the equipment?
What will be an ideal response?
Answer: Yes, purchase the equipment because it has a positive NPV of $168,990. (The IRR of 15.18% is greater than the hurdle rate of 14 %.)
Year 0 1 2 3 4 5
Initial
Investment -$5,000,000
Change in
NWC -$500,000
Net Operating
Cash Flow $1,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000
Salvage Value $1,000,000
Net Cash Flow -$5,500,000 $1,500,000 $1,500,000 $1,500,000 $1,500,000 $2,500,000
PVCF $1,315,789 $1,154,201 $1,012,457 $888,120 $1,298,422
NPV $168,990
NPV = PV cash inflows - initial net cash flow
= CF ∗ - initial net cash flow
= $1,500,000 ∗ + - $5,500,000 = $168,990.
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