Question

Firm Abs will incur $5,000,000 in initial capital outlays in Year 1, $3,000,0000 in Year 2 and $1,000,0000 in Year 3. Since the company does not expect to be able to produce or sell its product until Year 2, it will not incur any labor and materials cost in Year 1. Based on marketing research and forecasting tools, Firm Abs to sell 6,000 units in Year 2 at a price of $320 and then expect that quantity to double in Year 3 and remain at that level in Years 5. However, they anticipate that the price will gradually reduce to $300, $270, and $240 in Years 3-5.

a. Calculate the costs and revenues over the five-year period without taking into the time value of money. What is the net profit of undiscounted costs and revenues?

b. Now calculate the net present value under the following scenarios and compare to your answer in a.

i. Calculate the net present value using discount rates of 10, 8, and 6 percent. Show your work.

ii. What would be your decision given your answers in i and ii? Explain. iii. Regardless of your answer in

iii., assume that your company decided to go forward with the investment. What would be the relevant costs to consider when deciding whether to shutdown at the beginning of Year 3? Year 4? Year 5?

Answer 1

I am solving for a and b. i) in the following table. The formula is given in the 2nd row.

End of Year	Initial Capital Outlays / Costs	Production Quantity	Production Price	Revenues	Net Cashflow	Disc Rate 10%	Disc Rate 8%	Disc Rate 6%
A	B	C	D	E=C*D	F=E-B	G=F/(1+10/100)^A	H=F/(1+8/100)^A	I=F/(1+6/100)^A
1	5000000			0	-5000000	-4545454.55	-4629629.63	-4716981.13
2	3000000	6000	320	1920000	-1080000	-892561.98	-925925.93	-961196.16
3	1000000	12000	300	3600000	2600000	1953418.48	2063963.83	2183010.14
4		12000	270	3240000	3240000	2212963.60	2381496.72	2566383.47
5		12000	240	2880000	2880000	1788253.41	1960079.61	2152103.54
Total	9000000			11640000	2640000	516618.96	849984.60	1223319.86

a. The total undiscounted costs over the five year period = 9,000,000

The total undiscounted revenue over the five year period =   11,640,000

Net profit over 5 year period = 11,640,000 - 9,000,000 = 2,640,000

b.

i.Net Present value at discount rate of 10% is 516,618.96

Net Present value at discount rate of 8% is 849,984.60

Net Present value at discount rate of 6% is 1,223,319.86

ii. Since the NPV is positive in all cases, so the company should go ahead with the investment in all the instances at all the given discount rates.

iii. In all the cases, the NPV is negative at the beginning of year 3, year 4 and year 5. It is only at the end of year 5 that the project turns positive in all the cases. So if the company decides to invest, it should not shutdown till the end of year 5 to ensure profitability.

However, what has not been considered is the total labour expenses. If the labour expenses are high enough that instead of a positive cashflow, the total cashflow is negative then it will be better to shutdown the project. SO the additional labour costs will be the deciding factor whether to continue or shutdown the unit.

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