I need this explained so that I understand how to solve it in the future. I have the answers but don't understand how to get to them.

Applying NPV: Capital Budgeting

Capital budgeting is a widely used financial tool based on the time value of money (discounted cash flows). The idea is that money in hand today is worth more than money received tomorrow. Using this foundation, capital budgeting balances inflows with outflows over time to determine the net present value (NPV) of an investment or its internal rate of return (IRR). Inherent in the use of capital budgeting is the need for management to establish some form of hurdle rate, which is a measure of the value of money over time. The hurdle rate is usually composed of at least three elements: 1) an interest charge or opportunity cost, 2) a measure of return above the interest charge, and 3) a measure of risk.

Problem

Savage Manufacturing is trying to decide whether to invest in a new CAD system for the design of its new front discharge concrete truck. The initial purchase price for the CAD system would be $12,500 for the hardware, software, and initial setup cost. An additional $2,500 would be required to rewire the drafting office for the CAD system. This CAD system is expected to reduce design times as well as eliminate duplication, reduce engineering changeovers, and improve overall product quality. The marketing and accounting departments have provided the following estimates for the after-tax cash flows for the expected savings from the CAD system over its five-year life. The CAD system will be retired at the end of year 5 with no salvage value (i.e., the system is worth nothing to the company at its end of life).

Year After-tax Cash Flow

1 $5,500

2 4,000

3 4,500

4 3,500

5 6,000

Your Answer

a. With an established policy of only adopting investments that

provide a return of 18% or more, should the CAD system be purchased?

b. What is the NPV for this potential investment?

c. What is the IRR?

d. What would the NPV be if a salvage value of $1,000 was expected?

(Hint: The salvage value is the residual value of the system at the end of year 5.

The salvage value improves the year 5 cash flow.)

e. Should Savage purchase the CAD system now?

f. What is the discount factor for the 5th year if the hurdle rate is 35 percent?

Answer key:

a. No

b. $ (299.49) (Parentheses indicate the NPV is negative)

c. 17.11%

d. $137.62

e. Yes

f. 0.223