Question

Scenario: A new product manager presents to you, the Chief Financial Officer, a proposal to expand operations that includes the purchase of a new machine. The product manager is certain that the positive cash flows, which exceed the initial outlay by $20,000 by the end of year 4, will bring both praise and approval. You explain the company uses a 12% discount rate for cash flows and project related budgeting. You take the time to present the details of the Net Present Value (NPV) model used to assess product proposals. The data is below.

Project Outflows to Buy Machine      

Day 1 Cash Out                     -$70,000 12% discount rate applied.

End Year 1 Cash Repayment            $10,000

End Year 2 Cash Repayment            $20,000

End Year 3 Cash Repayment            $30,000

End Year 4 Cash Repayment            $30,000

To educate the new manager, and as CFO, you take the time to evaluate the following:

• Assess the investment option when a 7% cost of capital discount rate, versus a 12% cost of capital discount rate is applied. Include values in your assessment. Provide the NPV at a 7% cost of capital discount rate.

Answer 1

At 7%:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=10,000/1.07+20,000/1.07^2+30,000/1.07^3+30,000/1.07^4

=$74190.36(Approx)

NPV=Present value of inflows-Present value of outflows  

=74190.36-70,000

=$4190.36(Approx)

Hence since NPV is positive;project must be accepted

At 12%:

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=10,000/1.12+20,000/1.12^2+30,000/1.12^3+30,000/1.12^4

=$65291.4(Approx)

NPV=Present value of inflows-Present value of outflows  

=65291.4-70,000

=$-4708.6(Approx)(Negative)

Hence since NPV is negative;project must be rejected.