Question

Lakeside Winery is considering expanding its winemaking operations. The expansion will require new equipment costing $673,000 that would be depreciated on a straight-line basis to zero over the 4-year life of the project. The equipment will have a market value of $180,000 at the end of the project. The project requires $50,000 initially for net working capital, which will be recovered at the end of the project. The operating cash flow will be $215,900 a year. What is the net present value of this project if the relevant discount rate is 15 percent and the tax rate is 34 percent?

• −$10,098

• −$11,968

• –$10,771

• −$12,889

• −$9,088

Answer 1

Initial Investment Cost

Initial Investment Cost = Cost of the fixed asset + Working capital required

= $673,000 + $50,000

= $723,000

Year 1-3 Cash flow = $215,900 per year

Year 4 Cash Flow = Annual cash flow + Working capital + After-tax market value

= $215,900 + $50,000 + [$180,000 x (1 – 0.34)]

= $215,000 + $50,000 + $118,800

= $384,700

The project's net present value

Year	Annual cash flows ($)	Present Value Factor (PVF) at 15.00%	Present Value of annual cash flows ($) [Annual cash flow x PVF]
1	215,900	0.869565	187,739
2	215,900	0.756144	163,251
3	215,900	0.657516	141,958
4	384,700	0.571753	219,953
TOTAL		712,902

The Net Present Value (NPV) of the Project = Present value of annual cash inflows – Initial investment costs

= $712,902 - $723,000

= -$10,098 (Negative NPV)

“Hence, the net present value of this project is -$10,098 (Negative NPV)”

NOTE

The formula for calculating the Present Value Inflow Factor (PVIF) is [1 / (1 + r)n], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.