Question

Thornley Machines is considering a 3-year project with an initial cost of $618,000. The project will not directly produce any sales but will reduce operating costs by $265,000 a year. The equipment is depreciated straight-line to a zero book value over the life of the project. At the end of the project the equipment will be sold for an estimated $60,000. The tax rate is 34%. The project will require $23,000 in extra inventory for spare parts and accessories. Should this project be implemented if Thornley's requires a 9% rate of return? Why or why not?

Answer 1

Thornley Machines should implement the project as it is expected to generate a positive return.

Step-by-step explanation:

To determine whether Thornley Machines should implement the project, we need to calculate the net present value (NPV) of the project. The NPV is calculated by discounting the cash flows of the project using the required rate of return. In this case, the initial cost is -$618,000, the annual cost savings are $265,000, and the salvage value is $60,000. After calculating the NPV, if it is positive, the project should be implemented, and if it is negative, the project should be rejected.

Using a 9% rate of return, the NPV can be calculated as follows:

Year 0: -$618,000

`Year 1: $265,000 / (1 + 0.09) = $243,119.27`

`Year 2: $265,000 / (1 + 0.09)^2 = $223,286.01`

`Year 3: $265,000 / (1 + 0.09)^3 + $60,000 / (1 + 0.09)^3 = $204,711.55`

NPV = -$618,000 + $243,119.27 + $223,286.01 + $204,711.55

= $52,116.82

Since the NPV is positive, the project should be implemented as it is expected to generate a positive return.