Planning for capital investments is an important function of management. You are
ID: 2354645 • Letter: P
Question
Planning for capital investments is an important function of management. You are provided with the following data concerning a proposed capital investment: cash cost $220,000, net annual cash flows $40,000, present value factor of cash inflows for ten years 5.65 (rounded). Determine the net present value, and indicate whether the investment should be made. (1) Explain the pros and cons of using this method to evaluate a capital expenditure (10 points) and (2) show all computations required to arrive at the correct solution. (15 points). (Points : 25)Explanation / Answer
The net present value (NPV) is beneficial because it shows whether the investment will be profitable, it takes into consideration the time value of money, it considers all cash flows, and it considers the risk of those future cash flows via the cost of capital. Its disadvantages are that it requires an estimate of the cost of capital and it is expressed in dollars, not as a percentage. Using the PV factor given, the net present value of the proposed capital investment is $(220,000) + [$40,000 × 5.65] = $(220,000) + $226,000 = $6,000.