Net Present Value Method - Example

Jeremy limited wishes to expand its output by purchasing a new machine worth 170,000 and installation costs are estimated at 40,000/=.  In the 4th year, this machine will call for an overhaul to cost 80,000/=.  Its expected inflows are:

                                                Shs.

                   Year 1                  60,000

                   Year 2                  72,650

                   Year 3                  35,720

                   Year 4                  48,510

                   Year 5                  91,630

                   Year 6                  83,715

This company can raise finance to purchase machine at 12% interest rate.

Compute NPV and advise management accordingly.

Solution

                                                                Shs.

Cost of machine at present value             170,000

Installation cost                                          40,000

                                                                 210,000

Overhaul cost in the 4^th year =          80,000

Discounting factor =                           (1.12)4

Consequently present value        = 80,000/(1.12)⁴

                                                     = Shs.50, 841.446

Sum present value of investment = 260,841.45

P_V inflows   = 60,000 / (1.12) + 72,650 / (1.12)² + 35,720 / (1.12)³ +48,510 / (1.12)⁴ +91,630 / (1.12)⁵ +83,715 / (1.12)⁶

Consequently:

NPV = 262,147.28 - 260,841.45

NPV   = 1,305.83

The NPV is positive and I would inform the management to invest.