Fresh Flour makes baking flour and sells its flour in 4 pound sacks or bags. The managers of Fresh Flour are considering whether the firm should make or buy the flour sacks. To make the sacks, Fresh Flour needs a $500,000 piece of equipment. Using this equipment, Fresh Flour can make a flour sack for $0.01 and, for simplicity, ignore taxes and assume that the $0.01 cost includes depreciation and all other costs. Fresh Flour would finance the $500,000 investment using its own funds and, if it purchased the flour sacks from another firm, it would pay $0.19 a flour sack. The life span of the equipment is 10 years and it has no salvage value at the end of the ten years. If the discount rate is 6 percent and the firm needs 400,000 flour sacks a year, what is the net present value of the equipment?
A)- $45,852
B)$31,520
C)$29,926
D)- $28,126

Question

Quizplus · Accepted Answer

To find the net present value (NPV) of the equipment, we need to calculate the present value of the cash inflows from using the equipment (saving money by making the flour sacks in-house) and the present value of the cash outflows (investing in the equipment).

First, let's calculate the cost of buying the flour sacks from another firm:
$0.19/sack x 400,000 sacks/year = $76,000/year

Next, let's calculate the cost of making the sacks in-house:
$0.01/sack x 400,000 sacks/year = $4,000/year

The annual cash inflows from making the sacks in-house are:
$76,000/year - $4,000/year = $72,000/year

To calculate the present value of the cash inflows and outflows, we can use the following formula:

NPV = -Initial Investment + PV of Cash Inflows

Where PV is the present value.

The initial investment is $500,000, which is the cost of the equipment.

The PV of the cash inflows is:

PV = CF / (1 + r)^n

Where CF is the cash flow, r is the discount rate, and n is the number of years.

Using a financial calculator or spreadsheet, we can calculate that the PV of the cash inflows over 10 years is:

PV = $72,000 x [(1 - 1/(1+0.06)^10)/0.06] = $552,926

Therefore, the NPV is:

NPV = -$500,000 + $552,926 = $52,926

Since the NPV is positive, it is financially beneficial for Fresh Flour to make the sacks in-house rather than purchasing them from another firm.

However, the question asks for the net present value of the equipment itself, not the decision of whether to make or buy the sacks. To determine this, we simply subtract the initial investment from the NPV:

Net present value of the equipment = NPV - Initial Investment = $52,926 - $500,000 = -$447,074

Since the net present value is negative, the best choice would be to not invest in the equipment and instead purchase the flour sacks from another firm.

Fresh Flour Makes Baking Flour and Sells Its Flour in 4