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A cloth manufacturing firm is deciding whether or not to invest in new machinery.The machinery costs $45,000 and is expected to increase cash flows in the first year by $25,000 and in the second year by $30,000.The firm's current fixed costs are $9,000 and current marginal cost are $15.The firm currently charges $18 per unit.
-If the interest is 5%,should the firm undertake the investment?

Question

​Use the following setup for question
A cloth manufacturing firm is deciding whether or not to invest in new machinery.The machinery costs $45,000 and is expected to increase cash flows in the first year by $25,000 and in the second year by $30,000.The firm's current fixed costs are $9,000 and current marginal cost are $15.The firm currently charges $18 per unit.
-​If the interest is 5%,should the firm undertake the investment?
A)​Yes,since NPV=0
B)Yes,since NPV<0
C)Yes,since NPV>0
D)​No,since NPV=0

Quizplus · Accepted Answer

To determine whether the firm should undertake the investment, we need to calculate the net present value (NPV) of the investment.

NPV = -Initial investment + PV of expected cash flows

PV of expected cash flows = (Cash flow year 1 / (1 + interest rate)^1) + (Cash flow year 2 / (1 + interest rate)^2)

PV of expected cash flows = ($25,000 / 1.05) + ($30,000 / 1.05^2) = $51,624

NPV = -$45,000 + $51,624 = $6,624

Since the NPV is positive, the investment is expected to generate returns greater than the required rate of return (5%) and therefore, it is recommended that the firm undertake the investment.

​Use the Following Setup for Question

Use the Following Setup for Question