Question

NPV: Basic Concepts

Buena Vision Clinic is considering an investment that requires an outlay of $600,000 and promises a net cash inflow one year from now of $810,000. Assume the cost of capital is 10 percent.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Break the $810,000 future cash inflow into the three components shown below. Enter all your answers as positive amounts.

a. The return of the original investment	$600,000
b. The cost of capital	$60,000
c. The profit earned on the investment	$150,000

2. Now, compute the present value of the profit earned on the investment.
$

3. Compute the NPV of the investment. When required, round your answer to the nearest dollar.
$

Compare this with the present value of the profit computed in Requirement 2. What does this tell you about the meaning of NPV?
Net present value represents the present value of future profits

Answer 1

Solution 1:

a. The return of the original investment = $600,000

b. The cost of capital = $600,000*10% = $60,000

c. The profit earned on investment = $810,000 - $600,000 - $60,000 = $150,000

Solution 2:

Present value of profit earned on investment = $150,000 * PV factor at 10% for 1st period

= $150,000 * 0.90909 = $136,364

Solution 3:

Computation of NPV - Buena Vision Clinic
Particulars	Period	Amount	PV factor at 10%	Present Value
Cash outflows:
Initial investment	0	$600,000.00	1	$600,000
Present Value of Cash outflows (A)				$600,000
Cash Inflows
Annual cash inflows	1	$810,000.00	0.90909	$736,364
Present Value of Cash Inflows (B)				$736,364
Net Present Value (NPV) (B-A)				$136,364

Solution 4:

Net present value represents the present value of future profits