Question

Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's value? a. $ 677.69 b. $1,098.89 c. $1,179.46 d. $1,237.76 e. $1,312.31

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J	K	L
2
3		The value increased by the project will be the NPV of the project.
4		Since patent will expire in four years, therefore project life is 4 Year.
5		Process S has life of 2 Years and will be replaced after 2 Years.
6
7		Cash Flow of process S will be as follows:
8		Year	0	1	2	3	4
9		Cash Flow	-8000	5000	=5000-8000	5000	5000
10
11		Cash Flow of process L will be as follows:
12		Year	0	1	2	3	4
13		Cash Flow	-11500	4000	4000	4000	4000
14
15		Calculation of NPV of process S:
16
17		NPV of the project is present value of future cash flows discounted at required rate of return less the initial investment.
18		Given the following cash flow and WACC, NPV for the project can be calculated as follows:
19		Year	0	1	2	3	4
20		Cash Flow (FCF)	=D9	=E9	=F9	=G9	=H9
21		Cost of capital (i)	0.1
22		(P/F,i,n) for each year		=1/((1+$D21)^E19)	=1/((1+$D21)^F19)	=1/((1+$D21)^G19)	=1/((1+$D21)^H19)
23		Present Value of cash flows = FCF*(P/F,i,n)		=E20*E22	=F20*F22	=G20*G22	=H20*H22
24		Present value if future cash flows	=SUM(E23:H23)	=SUM(E23:H23)
25
26		NPV for Project	=Present value fo future cash flows - Initial investment
27			=D24+D20	=D24+D20
28
29		Hence NPV for Project S	=D27
30
31		Calculation of NPV of process L:
32
33		NPV of the project is present value of future cash flows discounted at required rate of return less the initial investment.
34		Given the following cash flow and WACC, NPV for the project can be calculated as follows:
35		Year	0	1	2	3	4
36		Cash Flow (FCF)	=D13	=E13	=F13	=G13	=H13
37		Cost of capital (i)	0.1
38		(P/F,i,n) for each year		=1/((1+$D37)^E35)	=1/((1+$D37)^F35)	=1/((1+$D37)^G35)	=1/((1+$D37)^H35)
39		Present Value of cash flows = FCF*(P/F,i,n)		=E36*E38	=F36*F38	=G36*G38	=H36*H38
40		Present value if future cash flows	=SUM(E39:H39)	=SUM(E23:H23)
41
42		NPV for Project	=Present value fo future cash flows - Initial investment
43			=D40+D36	=D24+D20
44
45		Hence NPV for Project L	=D43
46
47		Since NPV of the project S is higher therefore project S is better project.
48		Hence value added by better project is	=D29
49		Thus option (d) is correct.
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