Question

A project requires an additional commitment of $100,000 in net working capital in each of years 1 to 4. These extra investments can be recovered in year 5 when the project comes to an end. What is the effect on NPV?

Answer 1

Net Present Value will get decreased due to the following reason:

While calculating Net Present Value, we have to calculate Present value of the cash outflows which is subtracted from Present value of Cash inflows. So, the investment of working capital in the project each year would be cash outflow which is brought to present value and at the end of year 5 when the project comes to an end it will be cash inflow to the project. Now, the present value of cash inflow would be less as compared to present value of cash outflow because cash inflow is received in year 5 whose value would be very less compared to cash outflow of $ 100,000 which is invested each year and would be having a greater value.

Present value of Cash inflow in this case = Amount / (1 + r )^t where r is rate of return, t is the time which is 5 years. = 400000 / (1 + r )⁵

Present value of cash outflow in this case = 100000 / (1 + r )¹ + 100000/ (1 + r )² +100000/(1 + r )³ + 100000/(1 + r )⁴   

So if cash inflow would be less than outflow it will automatically decrease the Net present value.