Question

Forise Water Company drills small commercial water wells. The company is in the process of analyzing the purchase of a new drill. Information on the proposal is provided below.

Initial investment:

Asset $600,000

Working capital $ 120,000

Operations (per year for four years):

Cash receipts $450,000

Cash expenditures $ 190,000

Disinvestment:

Salvage value of drill (existing) $ 50,000

Discount rate 18%

What is the net present value of the investment? Assume there is no recovery of working capital.

Answer 1

What is the net present value of the investment?

Answer: $29,416.07

Workings

Formula for calculating Net Present Value is as follows

NPV     = Present Value of Future cash flows – Initial investment

Initial investment           = Assets price + Working capital – Salvage value of old Drill

                                                = $600,000 + $120,000 - $50,000

                                                = $670,000

Present value of future cash flows, we need to calculate cash flow for 4 years. Present value of a cash flow can be found out using the following formula.

Where,

R = required rate of return = 18% given in problem.

N = number of years

Present value of future cash flows calculation

Year	Cash receipt	Cash Expenditure	Cash Flow (i.e. Cash receipt – Cash Expenditure)	Workings for present Value	Present Value
1	$ 450,000	$ 190,000	$ 260,000	=$260,000 ÷(1.18)1	$220,338.98
2	$ 450,000	$ 190,000	$ 260,000	=$260,000 ÷(1.18)2	$186,727.95
3	$ 450,000	$ 190,000	$ 260,000	=$260,000 ÷(1.18)3	$158,244.03
4	$ 450,000	$ 190,000	$ 260,000	=$260,000 ÷(1.18)4	$134,105.11
Present value of future cash flows	$699,416.07

NPV Calculation

NPV     = Present Value of Future cash flows – Initial investment

                = $699,416.07 - $670,000

            = $29,416.07