Question

8. Cliff Corp. (CC) is considering moving its widgets division to a new building costing $220,000. The new building will be more efficient and will save the widget division $20,000/year in operating expenses indefinitely. The move will also allow the gadget division to expand its operations in the old building resulting in $4,000/year of additional cashflow. CC’s cost of capital is 10%. Should CC move the widget division? What is the NPV of the move? If all of the cost of the new building is allocated to the widget division, will the widget division manager be in favor of the move?

Answer 1

Net Present Value= Present Value of Cash Inflow(PVCI)- Present Value of Cash Outflow (PVCO)

Present value of Cash Outflow is the amount we have spent, or the net outgo from the business multiplied by the time value factor.

Whereas Present value of Cash Inflow refers to the amount that we have received or savings from the business multiplied by the time value factor.

For making comparison between the cash outflow and the cash inflow we have to take care of one thing that our time base must be same with which we are making a comparison, i.e. PVCI and PVCO should belong to the same time factor.

Here in the given case,

PVCO at time 0*=2.20 lacs * 10%= 22,000

PVCI at time 1**= Savings= Savings in Widget Division + Additional Cash Flow in Gadget Division

=> 20,000+4,000=24,000

It is a general principle that the savings will flow to the company over an year, as a result we have to make the time base same in order to make a logical comparison.

Now PVCI at time 0= 24000*(1/1+0.1)=24000*.909=21,818

Net Present Value= PVCI- PVCO

=> 21,818-22,000=-182

Here in the given case, if cost of the building is allocated to the widget division, than it will result in additional cash outflow of Rs 182, hence widget division manager would be in against the move.

* Time 0 means the value of the amount today.

* *Time 1 means the value of the amount after 1 year.