Question

This time Ron is at his wits end. He has sent the accounting team out of his office to rework the numbers. "That simply cannot make sense. If I'm making more than I'm spending, it's a good decision; right?" He walks into your office for your weekly meeting and asks rhetorically "If I'm spending $2,000,000 today on a new plant and that new plant is going to produce $205,000 for each of the next ten years in income how can that possibly be a negative net decision for the company?"

Can you explain to Ron the concept involved and how that could be a "negative net decision"?

Provide constructive feedback to at least two other students' postings.

Answer 1

Let us consider Mr. Ron's figures and try to give him an idea in the real world.
Assuming there is an inflation of 2% and it remains consistent for the next 10 years.
This would mean that the NEW equipment that is worth $2,000,000 today will be worth 2,000,000 X (1 + 2%)^10 = $2,437,989, if purchased new after 10 years. On the contrary, the income generated is only $205,000 X 10 = $2,050,000.
This is the time value of money. If see nominally we are bound to receive $205,000 every year for the next 10 years which totals up to $2,050,000 and is more than our initial investment. But factoring in the inflation or the opportunity cost or the time value of money the present value of these $205,000 is very less as explained in the table below (assuming a meagre 2% rate)

Period	Amount	PV Factor	PV
		1/(1+2%)^Period	Amount X PV Factor
0	$ (20,00,000)	1.00	$                (20,00,000)
1	$      2,05,000	0.98	$                     2,00,900
2	$      2,05,000	0.96	$                     1,96,800
3	$      2,05,000	0.94	$                     1,92,700
4	$      2,05,000	0.92	$                     1,88,600
5	$      2,05,000	0.91	$                     1,86,550
6	$      2,05,000	0.89	$                     1,82,450
7	$      2,05,000	0.87	$                     1,78,350
8	$      2,05,000	0.85	$                     1,74,250
9	$      2,05,000	0.84	$                     1,72,200
10	$      2,05,000	0.82	$                     1,68,100
			$                  (1,59,100)

As is clearly evident, the net present value is NEGATIVE which means that when adjusted for time value of money or the REAL returns, this project does not hold up well. It does not generate anything for the organization.

It turns out to be a negative net decision.