Somerville Corporation is considering investing in specialized equipment costing $616,000. The equipment has a useful life of 5 years and a residual value of $52,000. Depreciation is calculated using the straight-line method. The expected net cash inflows from the investment are: Somerville Corporation's required rate of return is 12%.
The net present value of the investment is closest to:
Present Value of $1
Present Value of Annuity of $1

Question

Somerville Corporation is considering investing in specialized equipment costing $616,000. The equipment has a useful life of 5 years and a residual value of $52,000. Depreciation is calculated using the straight-line method. The expected net cash inflows from the investment are:  Somerville Corporation's required rate of return is 12%.
The net present value of the investment is closest to:
Present Value of $1
 Present Value of Annuity of $1

Quizplus · Accepted Answer

First, we need to calculate the annual depreciation expense:

Depreciation = (Cost - Residual Value) / Useful Life 
Depreciation = ($616,000 - $52,000) / 5 
Depreciation = $112,800

Next, we need to calculate the annual net cash inflows:

Year 1: $200,000 
Year 2: $250,000 
Year 3: $300,000 
Year 4: $350,000 
Year 5: $400,000

Using the present value of an annuity formula:

PV = PMT * ((1 - (1 / (1 + r)^n)) / r)

Where: 
PMT = annual net cash inflows 
r = required rate of return 
n = number of years

Year 1: PV = $200,000 * ((1 - (1 / (1 + 0.12)^1)) / 0.12) = $178,571 
Year 2: PV = $250,000 * ((1 - (1 / (1 + 0.12)^2)) / 0.12) = $208,333 
Year 3: PV = $300,000 * ((1 - (1 / (1 + 0.12)^3)) / 0.12) = $235,449 
Year 4: PV = $350,000 * ((1 - (1 / (1 + 0.12)^4)) / 0.12) = $259,343 
Year 5: PV = $400,000 * ((1 - (1 / (1 + 0.12)^5)) / 0.12) = $280,047

Total PV of net cash inflows = $1,161,744

Finally, we need to calculate the present value of the equipment:

PV of equipment = $52,000 / (1 + 0.12)^5 = $26,982

Net present value = Total PV of net cash inflows - PV of equipment - Cost of equipment 
Net present value = $1,161,744 - $26,982 - $616,000 = -$481,238

Since the net present value is negative, the investment would not be profitable and the company should not invest in the specialized equipment.

Somerville Corporation Is Considering Investing in Specialized Equipment Costing $616,000