In: Finance
A construction company is evaluating an investment project consisting in developing a new residential building on a plot of land. The cost of the land, to be paid in t=0, is €500K and construction would take 2 years. Construction costs are estimated to be €650K in t=1 and €650K in t=2. The building would then generate an annual cash flow of €250K in perpetuity, starting from t=3. If the cost of capital is 8%, the NPV of this project is closest to:
A. €1,190K B. €1,020K C. €1,466K D. €1,357K
Value of perpetuity in year 2 can be computed using formula for PV of perpetuity as:
PV = C/r
C = Periodic cash flow starting in next year = € 250 K
r = Cost of Capital = 0.08
Value of cash inflow in year 2 = € 250 K/0.08
= € 3,125 K
Total cash flow in year 2 = € 3,125 K - € 650 K = € 2,475 K
Cash outflow in year 0, 1 are € 500 and € 650 respectively
NPV = PV of cash inflows – PV of cash out flows
Year |
Cash Flow (C) |
Computation of PV Factor |
PV Factor @ 8 % (F) |
PV (C x F) |
0 |
-€500 K |
1/ (1+0.08)0 |
1 |
-€500 K |
1 |
-€650 K |
1/ (1+0.08)1 |
0.925925925925926 |
-€601.8518519 K |
2 |
€2,475 K |
1/ (1+0.08)2 |
0.857338820301783 |
€2,121.9135802 K |
NPV |
€1,020.0617283 K |
NPV of the project is € 1,020.0617283 K or € 1,020 K
Hence option “B. € 1,020 K” is correct answer