Question

The Hasty Rabbit Corporation makes lightweight sneakers for rabbits. The company has had amazing success with its latest sneaker design, Swifty Feet, and is considering expanding the production capacity. The expansion will increase production volume by 1,300 pairs per year and will cost $125,000 and the rate is 8.6%.

The company's accountants have calculated that the additional cash flows from the expansion will be as follows:

Year 1: $40,000Year 2: $42,000Year 3: $43,000Year 4: $44,000Year 5: $45,000

• Which is the net present value of the investment?

• Would you recommend doing the investment?

Answer 1

The Net present value is the difference between the present values of cash inflows and the present value of cash outflows.

Cost of expanding = $125,000

Required return = 8.6%

The present value of cash outflows = Cost of expanding = $125,000

Cash flow from expansion is

Yr	0	1	2	3	4	5
Cash flow	-125,000	40,000	42,000	43,000	44,000	45,000

The Present Value of inflows =     

=  

= 36832.4 + 35611.4 + 33572.1 + 31632.5 + 29789.5

= $167,438

Net Present Value = Present value of inflows - Present value of outflows

= 167,438 - 125,000

= $42,438

Because the present value of the expected cash flows exceeds the original investment by $42,438, we should expand the production line of Swifty Feet.