Question

You are the manager of a local factory that produces plastic bottles for soft drink manufacturers. Your colleague brings an assembly line project to a meeting with the following data:  

           Estimated life of assembly line:                      5 years

            Initial investment cost:                                   $740,000

            Estimated salvage value:                                 none

            Current interest rates:                                      15 percent

            Estimated Cash Flow Analysis

            Year                                        Expected Cash Flow

            1                                              $360,000

            2                                              240,000

            3                                              100,000

            4                                                  25,000

            5                                                  20,000

                                               

            a) As your colleague begins going through the analysis with the CEO, you wait until he pauses and state, “I can tell already this is not an investment we should pursue.”  Your colleague asks how you could possible know that from looking at the data for one minute. How DO you know?

            b) Suppose you are given the same assembly line data, but now interest rates have fallen to 0.05 percent. Do you think the company should purchase the new line? How can you know that for certain?

Answer 1

Solution:
a)
Initial Investment cost i.e Present value of inflow
We would calculate the NPV of project, If NPV of the project is positive we should go
ahead with the project, otherwise we should not make investment in this project
NPV of project = Present Value of inflow - Present Value of Outflow
Year		Cash flow	Discounting factor @ 15%	Working		Present value of Cash Flow
		a	b			c = a*b
1	$	360000	0.869565217	(1/1.15^1)	$	313043.4783
2	$	240000	0.756143667	(1/1.15^2)	$	181474.4802
3	$	100000	0.657516232	(1/1.15^3)	$	65751.62324
4	$	25000	0.571753246	(1/1.15^4)	$	14293.83114
5	$	20000	0.497176735	(1/1.15^5)	$	9943.534706
						584506.9475
						-155493.0525
NPV of project = Present Value of inflow - Present Value of Outflow
$584506.95-$740000
$-155493.05
Since the NPV of Project is Negative, we should not pursue this investment option.
b)
If interest rate have fallen to 0.05% , we will calculate the revised NPV
NPV of project = Present Value of inflow - Present Value of Outflow
Year		Cash flow	Discounting factor @ 0.0005%	Working		Present value of Cash Flow
		a	b			c = a*b
1	$	360000	0.99950025	(1/1.0005^1)	$	359820.09
2	$	240000	0.99900075	(1/1.0005^2)	$	239760.1799
3	$	100000	0.998501499	(1/1.0005^3)	$	99850.14988
4	$	25000	0.998002498	(1/1.0005^4)	$	24950.06244
5	$	20000	0.997503746	(1/1.0005^5)	$	19950.07491
						744330.5571
						4330.55706
NPV of project = Present Value of inflow - Present Value of Outflow
$744330.56-$740000
$4330.56000000005
Since NPV of project is Positive , we can purchase the new line.