A carpet manufacturer, whose discount rate is 10%, can purchase texturizing equipment for $1,250,000 to process yarn. Incremental income before straight line depreciation from sales of texturized carpets is projected over the next five years as $95,000, $165,000, $357,000, $725,000 and $315,000, respectively. The company believes that the fashion will pass and demand in Year 6 will all but disappear. The machine can be sold at the end of Year 5 for $250,000. What should you advise the company to do?

Question

Quizplus · Accepted Answer

To determine the net present value (NPV) of the investment, we need to discount each incremental income by the 10% discount rate and subtract the initial cost of $1,250,000. Then, we add the salvage value of the equipment at the end of Year 5, discounted to its present value.

NPV = -1,250,000 + 95,000/1.1 + 165,000/1.1^2 + 357,000/1.1^3 + 725,000/1.1^4 + (250,000/1.1^5) 
= $86,952.13

Since the NPV is positive, the investment is expected to generate more than the required rate of return, and we should advise the company to purchase the equipment. The other ratios (ARR) or negatives (NPV and ARR) are not applicable or correct.

A Carpet Manufacturer, Whose Discount Rate Is 10%, Can Purchase