Question

A project has an initial cost of $1,000,000 and is expected to last for 2 years. In year 1, depreciation charge will be $100,000 and earnings are expected to be $164,747. In year 2, depreciation will be $100,000 and earnings are expected to be $208,905. Assume the required return is 8%. What is the value of this project? Please use a formula to answer this question.

Answer 1

Let earnings = E

Depreciation = D

Rate of interest = r = 0.08

Present value = PV = $1,000,000

The project value (V) should be calculated by the following formula:

V = {(E + D) / (1 + r)^1} + {(E + D) / (1 + r)^2} – PV

    = {(164,747 + 100,000) / 1.08^1} + {(208,905 + 100,000) / 1.08^2} – 1,000,000

    = (264,747 / 1.08) + (308,905 / 1.1664) – 1,000,000

    = 245,136.11 + 264,836.25 – 1,000,000

    = - $490,027.64 (Answer)

The value becomes negative; therefore, the project should not be taken.