Question

Problem 13-16 Net Present Value Analysis [LO13-2]

Windhoek Mines, Ltd., of Namibia, is contemplating the purchase of equipment to exploit a mineral deposit on land to which the company has mineral rights. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with opening and operating a mine in the area:

Cost of new equipment and timbers	$	430,000
Working capital required	$	215,000
Annual net cash receipts	$	150,000	*
Cost to construct new roads in year three	$	63,000
Salvage value of equipment in four years	$	88,000

*Receipts from sales of ore, less out-of-pocket costs for salaries, utilities, insurance, and so forth.

The mineral deposit would be exhausted after four years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company’s required rate of return is 18%.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

a. What is the net present value of the proposed mining project?

b. Should the project be accepted?

Answer 1

Solution:

(Amount in $)

PART A - Calculation of Net Present Value (NPV) of Project

1. Calculation of Present Value Cash Out Flows of Project

Particular	Amount	Period /Year	PV Factor @ 18%	PV of Amount
Cost of new equipment and timbers	430,000	0 ( at start of the project)	1	430,000
Working capital	215,000	0	1	215,000
Cost to construct new roads in year three	63,000	3	0.6886	38341.80
Total Present Value of Cash Outflow				683,341.8

2. Calculation of Present Value of Cash Inflow of project

Particular	Amount	Period /Year	PV Factor @ 18%	PV of Amount
Annual Revenue	150,000	1-4	2.6898 ( this is CPVF Refer to Note 1)	403,470
Salvage value of equipment sold	88,000	4	0.5157	45,381.6
Working Capital released	215,000	4	0.5157	110,875.5
Total Present Value of Cash Inflow of project				559,727.1

NPV of Project = Total Present value of Cash inflow - Total Present value of cash outflow

= 559,721.1 - 683,341.8

= - 123,620.7 (Negative)

PART B:

The project should not be accepted because the NPV is Negative. Hence the company should avoid this project otherwise will suffer the loss.

NOTE:

1. Cumulative Present value factor for 18% is used to calculate the annual revenue present value because the amount and time period to receive is the same. Hence in place of multiplying annual cash inflow with each year's present value, we can multiply the amount with cumulative factor.

2. The answer is solved based on 4 decimals in the present value factor. hence if you calculate with a higher decimal amount can differ to a minor extent but the overall decision and NPV of the project remain the same.

3. NPV method is used to evaluate the project or offer by determining the value of all cash inflows and outflow at the present value of a desirable discounting rate.