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 $ 5.15 million per year. Your​ up-front setup costs to be ready to produce the part would be $ 7.92 million. Your discount rate for this contract is 7.7 %.

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) NPV Rule

PARTICULARS	YEAR-1	YEAR-2	YEAR-3
(A) CASH FLOWS (in million)	$5.15	$5.15	$5.15
(B)DISCOUNT RATE(7.7%) (1/ 1(1+R%)^ number of year)	0.928	0.862	0.8006
DISCOUNTED CASH FLOWS (A*B) (in million)	$4.779	$4.439	$4.123

CUMULATIVE DISCOUNTED CASH FLOW = $4.779+ $4.439+ $4.123 = $ 13.3412 million

DISCOUNTED CASH FLOW IS $ 13.3412 and Initial investment is $ 7.92 million.

It means NPV is positive ($ 13.3412 - $ 7.92 = $ 5.4212 million).

NPPV = Present Value cashflow - Present Value cash outflow.

NPV RULES-

A. NPV Is negative,which means cumulative discounted cash flow is less than outflow in such case the contract expect to result in a Net Loss for the co.

B. if NPV is positive- company can expect a profit and should invest in the contract.

C. and if NPV is zero- the contract is not expected to result no profit no loss for the company.

Hence, the contract should be accepted.

b)Once contract is accepted,the shareholder's wealth would increase because Net Present Cash Flow is positive

There will be an increase of $5.4212 million in company wealth.