Question

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:

• How would the Time Value of Money concept results in a discounted cash flow in year 4 (an amount less than $30,000)?

Answer 1

We know that a dollar in future is worth less than a dollar today as the dollar today can be invested to earn interest and thus will be worth more than a dollar in future

Or, in other words to get 30000 in year 4 we need to invest only 19065 and discounted cash flow in year 4 is an amount less than $30,000

Present or Discounted Value=Future Value/(1+r)^n=30000/1.12^4
=19065.5423521