Question

A corporation makes an investment of $20,000 that will provide the following cash flows after the corresponding amounts of time:

Year 1 - $10,000
Year 2 - $10,000
Year 3 - $2,000

Should the company make this investment? What is the net present value at a 7 percent discount rate? Round your answer to two decimal points.

Answer 1

As the corporation is making an investment, its a cash outflow of $20,000.

The company is generating cash inflow on the project as follows:

Year 1 - $10,000

Year 2 - $10,000

Year 3 - $2,000

Now in order to know if the company should really make the above investment, we need to calculate the NPV(Net Present value) of the project. If the NPV is positive, then the company can move forward making the investment and if the NPV is negative, the company should not venture on such project.

NPV of any project can be calculated as follows:

NPV = Present value of Cash inflows - Present value of Cash Outflows

As given, the present value of cash outflows is $20,000

So, we now have to calculate the Present value of Cash inflows.

For calculating Present value of Cash inflows, we have to discount each year's cash inflow by the given discount rate of 7%. Considering that the Cash Inflows are generated at the end of each year, the present value of cash inflows of each year is as follows:

Year 1 Cash inflows : $10,000 / (1+7%)^1 = $9,346

  Year 1 Cash inflows : $10,000 / (1+7%)^2 = $8,735

Year 1 Cash inflows : $2,000 / (1+7%)^3 = $1,633

Total value of cash inflows = $9,346 + $8,735 + $1,633 = $19,714

NPV = Present value of Cash inflows - Present value of Cash Outflows

NPV = $20,000 - $19,714 = - $286

We can see that the NPV is negative. Therefore, it is advised that the company should not invest in the project.