Question

Consider a hypothetical economy that has NO tax. ABC Ltd. is considering investing in a 2-year project which is expected to generate the following year-end cash flows: C1 = $110 million, C2 = $115 million. The yearly discount rate for the project is 10%. The initial cost of the project is $200 million.

(f) Now suppose that of the $200m initial expenditure, $50m was used for the purchase of a machine that has an estimated economic life of four years. The machine will be fully depreciated (i.e., zero book value at the end of the machine’s economic life) on a straight-line basis and expected to have a resale value of $35m at the end of the project. (i) Explain how this will affect the size of the terminal (end-of-project) cash flows. (ii) How will this affect the NPV and the acceptance/rejection of the project (as compared to part (a))? Show your calculations.

Answer 1

Step 1: Calculation of NPV without the salvage value:

Initial cost of the project	200,000,000	(A) = Given in question
Cash flow in year 1	110,000,000	(B) = Given in question
Cash flow in year 2	115,000,000	(C) = Given in question
Discount rate	10%	(D) = Given in question
Discount factor for year 1	0.909	(E) = 1/(1+(D))^1
Discount factor for year 2	0.826	(F) = 1/(1+(D))^2
Calculation of Net Present Value
Discounted Cash flow in year 1	100,000,000	(G) = (B)*(E)
Discounted Cash flow in year 2	95,041,322	(H) = (C)*(F)
Initial cost of the project	(200,000,000)	(A)
Net Present Value	(4,958,678)	(I) = (G)+(H)-(A)

Project has a negative Net Present Value of $4,958,678 and hence project should be rejected.

Step 2: If machine has resale value of $35M at end of year 2

Resale value of machine	35,000,000	(J) = Given in question
Discounted Resale value of machine in year 2	28,925,620	(K) = (J)*(F)

Present Value of resale value of $35M at end of year 2 is $28,925,620 and thus terminal cash-flow increases by $28,925,620 (answer to (i) )

Step 3: Calculation of revised NPV considering the resale value

Net Present Value without considering the resale value = -$4,958,678

Present Value of resale value = $28,925,620

Revised Net Present Value = -$4,958,678+$28,925,620 = $23,966,942

Resale value positively affects the NPV by making it as positive $23,966,942. Since NPV is positive now, project can be accepted ((answer to (ii) ).