Question

Your factory has been offered a contract to produce a part for a new printer. The contract would last for 33

years and your cash flows from the contract would be $5.12 million per year. Your upfront setup costs to be ready to produce the part would be $7.89

million. Your discount rate for this contract is 8.3%.

a. What does the NPV rule say you should​ do?

b. If you take the​ contract, what will be the change in the value of your​ firm?

Answer 1

(a)-Net Present Value (NPV) of the Project

Net Present Value (NPV) of the Project = Present Value of annual cash inflows – Present Value of outflows

= [CF1/(1 + r)¹ + CF2/(1 + r)² + CF3/(1 + r)³] – Initial Investment

= [$5.12/(1 + 0.083)¹ + $5.12/(1 + 0.083)² + $5.12/(1 + 0.083)³] – $7.89

= [($5.12/1.083) + ($5.12 / 1.17289) + ($5.12 / 1.27024)] - $7.89

= [$4.73 + $4.37 + $4.03] - $7.89

= $13.13 - $7.89

= $5.24 Million

Here, the Net Present Value (NPV) method says that you should take the contract, since it has the positive NPV of $5.24 Million

(b)-Change in the value of the firm

If we take the contract, then the Change in the value of the firm would be $5.24 Million.