Question

Go Video, a manufacturer of video recorders, is considering a proposal to enter a new line of business. In reviewing the proposal, the company’s CFO is considering the following facts:

The new business will require the company to purchase additional fixed assets that will cost $800,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a straight-line basis over four years. (Annual depreciation will be $200,000 per year at t = 1, 2, 3 and 4.)

At the end of four years, the company will get out of the business and will sell the fixed assets at a salvage value of $100,000. The project will require a $40,000 increase in net operating working capital at t = 0, which will be recovered at t = 4. The company’s marginal tax rate is 30 percent. The new business is expected to generate $2.5 million in sales each year (at t = 1, 2, and 3). The operating costs excluding depreciation are expected to be $1.5 million per year. The project’s cost of capital is 12 percent.

What is the project’s net present value (NPV)?

Answer 1

PV of Cash flow = Cash Flow₁ / (1 + Discount Rate)¹ + Cash Flow₂ / (1 + Discount Rate)² + .......... + Cash Flow_n / (1 + Discount Rate)ⁿ   

NPV = PV of Cash Flows - PV of Cash Outflows

NPV of the project is $1,538,292.49 and the company should take the project as the NPV is positive.