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A company is considering a project with a 3 year life producing the following costs and revenues:
Cost of machine: 100,000
depreciation of machine (for 3 years): 20000 p.a.
residual value of machine: 40,000
annual cost of labor: 20,000
annual charge for foreman (10% apportioned): 5000
annual cost of components required: 18,000
annual net revenues from machine: 80,000
cost of capital: 20%what is the NPV?
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the text calculates the net revenues as:80- labor – components=42 … for each year from 1 to 3.
queries:
– i added back depreciation as well. why is depreciation not added back?
– i also added the costs of labor, components and the 5k for foreman’s charge to the INITIAL INVESTMENT, that is, the initial investment is 100+20+18+5=143,000.
why are not these costs added to initial investment?
thanks in advance
What we are after is the extra net cash flow each year.
The cash flows each year are the revenue, the labour and the cost of components.
Depreciation is not a cash flow and is therefore not relevant. I cannot understand why you want to add it to anything.
The initial investment is the amount that needs to be spent ‘now’. The labour and components are not being spent ‘now’ – they are being spent each year and we always assume payments are at the ends of years (so the first payment is in one years time).
The cost of the foreman is irrelevant because simply apportioning (sharing) an existing cost does not mean that we are spending any extra.
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