Question

Your factory has been offered a contract to produce a part for a new printer. The contract would last for 3

years and your cash flows from the contract would be $4.91 million per year. Your upfront setup costs to be ready to produce the part would be $7.99

million. Your discount rate for this contract is 7.6%.

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

= [$4.91/(1 + 0.076)¹ + $4.91/(1 + 0.076)² + $4.91/(1 + 0.076)³] – $7.99

= [($4.91/1.076) + ($4.91/1.15778) + ($4.91/1.24577)] - $7.99

= [$4.57 + $4.24 + $3.94] - $7.99

= $12.75 - $7.99

= $4.76 Million

Here, the Net Present Value (NPV) method says that you should take the contract, since it has the positive NPV of $4.76 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 $4.76 Million.