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 $ 5.09 million per year. Your upfront setup costs to be ready to produce the part would be $ 8.13 million. Your discount rate for this contract is 7.5 %. 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? a. What does the NPV rule say you should​ do? The NPV of the project is ​$ million.  ​(Round to two decimal​ places.)

Answer 1

The cash flows (in million) are:
Year 0:$8.13
Year 1:$5.09
Year 2:$5.09
Year 3:$5.09
Discount rate for the contract is 7.5%

NPV=-Initial cost + cash flow in year 1/(1+discount rate)^1+cash flow in year 2/(1+discount rate)^2+cash flow in year 3/(1+discount rate)^3
=-8.13+5.09/(1+7.5%)^1+5.09/(1+7.5%)^2+5.09/(1+7.5%)^3
=-8.13+5.09/(1.075)^1+5.09/(1.075)^2+5.09/(1.075)^3
=-8.13+5.09/1.075+5.09/1.155625+5.09/1.242296875
=-8.13+4.734883721+4.404542996+4.097249299
=5.106676016 or $5.12 (Rounded to two decimal places)

Part a:
As per NPV rule, a project with positive NPV should be accepted. As the NPV of the project is $5.12, it should be accepted.

Part b:
The value of the firm will increase by $5.12.