Use the information below to answer the following question(s).
Neptune Ltd. wants to expand its operations by manufacturing a new product line. New equipment will cost $225,000. Incremental sales are estimated at $150,000 per year for 6 years. Variable costs of producing the new product line are 52% of sales and incremental annual fixed costs are $25,000. The equipment can be salvaged after 6 years for 16% of its original cost. The company's required rate of return for new projects is 18%. Ignore income taxes.
-What is the net present value of the Neptune Ltd. investment?

Question

Quizplus · Accepted Answer

To calculate the net present value, we need to calculate the present value of incremental cash flows and then subtract the initial investment.

Year 0: 
Initial Investment: -$225,000

Years 1-6: 
Incremental Sales: $150,000 
Variable Costs (52% of sales): -$78,000 
Fixed Costs: -$25,000 
Incremental Operating Profit: $47,000 
Incremental Operating Cash Flow: $47,000

Using the formula for present value of annuity, we get:

PV of Incremental Operating Cash Flows = $47,000 * [(1-1/(1+0.18)^6)/0.18] = $182,277.26

Salvage Value in Year 6: 
16% * $225,000 = $36,000 
PV of Salvage Value = $36,000 / (1+0.18)^6 = $15,570.60

Total PV of Cash Flows = PV of Incremental Operating Cash Flows + PV of Salvage Value 
= $182,277.26 + $15,570.60 = $197,847.86

Net Present Value = Total PV of Cash Flows - Initial Investment 
= $197,847.86 - $225,000 = -$27,152.14

Therefore, the net present value of the Neptune Ltd. investment is ($47,277) (option B). Since the NPV is negative, the company should not undertake this investment.

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