Net Present Value Calculation
Net Present Value = $60,995.
Analysis of the Data
Net Present Value is one of the most popular methods used to evaluate financial decisions and projects. There are several other methods too, however, Net Present Value is the most credible one (Vance, 2003). Net Present Value compares the value of a dollar today, with the value of a dollar at some other point in time, for instance, a year from now. It is a useful tool because it provides a very simple decision-making criterion.
In the given case, Beautifully Fabulous Beauty Saloon has to analyze the decision to install a new automated production line. The evaluation is based upon the present value of all the cash outflows, the present value of all the cash inflows, and the difference between the two figures. Here, the company would have to make an initial investment of $40,000 to purchase the equipment; therefore, it is a cash outflow. Since it has to be done in the present time, so the cash flow factor is 1, and the value of the outflow is $40,000 in Present Value terms, as well. Secondly, in order to run the assembly line, Beautifully Fabulous Beauty Saloon would need to have a working capital of $3,000. This investment has to be made at the start of the project, and therefore, its cash flow factor will also be 1.
The installed assembly line will be able to generate a cash inflow of $15,000 annually. Since this value is in the form of an ordinary annuity, so in order to calculate the correct present value of this cash stream, a cash flow factor of 6.14457 has to be used. This factor yields a present value of $92,169, which means that the total worth of this entire cash stream in today’s dollar terms is $92,169. Another benefit of installing this assembly line would be that it would provide the company with a certain level of tax shield, depending upon the level of annual depreciation. Using a salvage value of $6,000 and straight-line depreciation method, the annual depreciation totals up to $3,400. At a tax rate of 40%, this depreciation would provide a tax shield of $1,360, annually. Since this is an annual shield it would also be treated as an annuity, and the corresponding cash flow factor will be used, which in this case would also be 6.14457. The total present value of this tax shield would be $8,357, and since it provides a tax advantage, it is treated as a cash inflow. Furthermore, at the end of the useful life of the equipment, i.e. 10 years from now, BSBF would be able to sell the equipment for $6,000, and since this would be sold 10 years in the future, it needs to be discounted by the appropriate cash flow factor, which in this case would be 0.38554. This would result in a present value of $2,313. Lastly, once the project is complete and the equipment is sold for its salvage value, the working capital that was being used would also be released (Edwards & Hermanson, 2007). Since it will be released 10 years from now, we also need to calculate its present worth, which totals up to $1,157, at a cash flow factor of 0.38554.
The Net Present Value, which is the gap between the present value of all the cash inflows and all the cash outflows, is $60,995.
Decision
As mentioned earlier as well, Net Present Value is a tool that is used to evaluate decisions, and decide whether a certain project is worth the required investment or not (Sulivan, 2011). The decision criterion is simple; if the Net Present Value is greater than zero, it means that the project is adding value to the firm, by generating a higher return than the investment needed (Smith, 2007). However, if the Net Present Value is a negative number, then it means that the project is unable to recover the money that is required to run the project.
In the given case, the Net Present Value is $60,995; it means that in terms of present value the project is likely to generate about $60,995 more than the investment needed for the project. This makes it a very favorable project, because it is generating a significant amount of money.
Assuming that the automated assembly line is the only investment opportunity available to Beautifully Fabulous Beauty Saloon, it should invest in the project. However, if Beautifully Fabulous Beauty Saloon has other opportunities as well, which can generate an even higher Net Present Value, only then BSBF should consider investing in them.
References
Edwards, J., & Hermanson, R. (2007). Accounting Principles: A Business Perspective. New York: Prentice Hall.
Smith, J. (2007). Handbook Of Management Accounting (4th ed.). Oxford: CIMA publication.
Sulivan, R. (2011). Financial Reporting And Analysis. Kansas: CFA institute.
Vance, D. (2003). Financial Analysis & Decision Making: Tools and Techniques to Solve Management Problems and Make Effective Business Decisions (4th ed.). New York: McGraw Hill.