Solving a typical business school NPV problem
MBA topics
I received the following email from a reader:
I’ve been trying to solve this problem for sometime with no success. I have also attempted using your information (How to calculate NPV) on the website, got close but still didnt get the solution.
Can you please help? Here is the question.
A fashion clothing company is considering investing in new machinery to improve its productivity over the next 5 years. You have been given the following information:
Sales are predicted to increase by $1,500,000 in year 1 and continue at this level.
The new machinery costs $10 million payable immediately.
It will be depreciated over 5 years on a straight line basis.
All the old machinery can be sold for $2 million.
The new equipment is more complicated and will cost $160,000 per year every year to maintain, as against the $100,000 for the old machines, but other running costs will be reduced by $120,000.
Finance for the purchase needs to be raised via a loan which requires annual interest payments of $300,000.
Wages will be reduced by $100,000 due to increased automation.
At the end of the five years the machinery will have a scrap value of $2million.
The feasibility study for this project (already completed and paid for) cost $200,000.
The cost of capital on investment appraisal for this level of risk is 7.5%.
Identify which of these items would be included in an NPV calculation and calculate the NPV. You may ignore tax and inflation.
This sounds like a typical NPV problem that you’d find in a business school finance class, and simplifies things by ignoring tax and inflation.
I’m laying out my reasoning and solution here, but I welcome any comments from others, as there may be other interpretations and I might just be plain wrong. (The beauty of a blog, right?)