Question

Introduction: The Assignment requires the application of the Net Present Value (NPV) model to assess investment options given cost of capital, commonly referred to as discount rates, and required rates of returns. You will explain the role of a discount rate in evaluating the NPV model and compare investment options as cost of capital increases or decreases. The use of a financial calculator will be required in this Assignment.

The following course outcome is assessed in this Assignment:

MT480-4: Assess investment options based upon cost of capital and expected returns.

Read the scenario and address all of the checklist items.

Scenario: A new product manager presents to you, the Chief Financial Officer, a proposal to expand operations that includes the purchase of a new machine. The product manager is certain that the positive cash flows, which exceed the initial outlay by $20,000 by the end of year 4, will bring both praise and approval. You explain the company uses a 12% discount rate for cash flows and project related budgeting. You take the time to present the details of the Net Present Value (NPV) model used to assess product proposals. The data is below.

Project Outflows to Buy Machine      

Day 1 Cash Out                     -$70,000 12% discount rate applied.

End Year 1 Cash Repayment            $10,000

End Year 2 Cash Repayment            $20,000

End Year 3 Cash Repayment            $30,000

End Year 4 Cash Repayment            $30,000

To educate the new manager, and as CFO, you take the time to evaluate the following:

Checklist:

• Evaluate how the Time Value of Money concept results in a discounted cash flow in year 4 (an amount less than $30,000).
• Assess the investment option using a 12% cost of capital discount rate by applying the NPV model. Include values in your assessment. Provide the NPV at a 12% cost of capital discount rate. Include values in your assessment.
• Assess the investment option when a 7% cost of capital discount rate, versus a 12% cost of capital discount rate is applied. Include values in your assessment. Provide the NPV at a 7% cost of capital discount rate.

Answer 1

Year	(a)Cash Inflows	(b)Discounting factor @12% for $1	(c)Discounting factor @7% for $1	(d)Present Value of Cash inflows @12%=(a)*(b)	Present Value of Cash inflows @7%=(a)*(c)
1	$10,000.00	0.892857143	0.934579439	$8,928.57	$9,345.79
2	$20,000.00	0.797193878	0.873438728	$15,943.88	$17,468.77
3	$30,000.00	0.711780248	0.816297877	$21,353.41	$24,488.94
4	$30,000.00	0.635518078	0.762895212	$19,065.54	$22,886.86
(A) Sum of Discounted cash inflows				$65,291.40	$74,190.36
(B) Sum of Discounted cash Outflows				$70,000.00	$70,000.00
(C) Net Present Value(A)-(B)				-$4,708.60	$4,190.36

Assessment of Investment Option @12%:

Since NPV is negative using 12% cost of capital This option should be rejected. Projects with positive NPV alone have to be considered.

Assessment of Investment Option @7%

Since NPV is positive using 7%.This option should be Accepted