Question

You are planning to invest in a project which costs $40 million today. The project will produce returns of $4 million per year for five years and the scrap value will be $20 million. That is, you will receive $4 million at the end of the year, for each of the next five years, and you will receive $20 million at the end of the fifth year.

Question (a) [2 marks] What is the net present value of the project (in $ million) if the cost of capital is 20% per year? $ Answer million

Question (b) [1 mark] Hence or otherwise if the cost of capital is 20% per year, should you invest in the project? Answer. Now suppose that the cost of capital for the project is 12% per year for the first three years, and 4% per year for subsequent years.

Question (c) [2 marks] What is the net present value of the project (in $ million)? $Answer million

Answer 1

a) Statement showing NPV

Particulars	0	1	2	3	4	5	NPV = sum of PV
Initial investment	-40000000
Annual Cash flow		4000000	4000000	4000000	4000000	4000000
Salvage value						20000000
Total cash flow	-40000000	4000000	4000000	4000000	4000000	24000000
PVIF @ 20%	1.0000	0.8333	0.6944	0.5787	0.4823	0.4019
PV	-40000000.00	3333333.33	2777777.78	2314814.81	1929012.35	9645061.73	-20000000.00

Thus NPV = -20000000$

b) Since NPV is negative, one should not invest in the project

c) If cost of capital for the project is 12% per year for the first three years, and 4% per year for subsequent years, Then NPV

Statement showing NPV

Particulars	0	1	2	3	4	5	NPV = sum of PV
Initial investment	-40000000
Annual Cash flow		4000000	4000000	4000000	4000000	4000000
Salvage value						20000000
Total cash flow	-40000000	4000000	4000000	4000000	4000000	24000000
PVIF @ 12%	1.0000	0.8929	0.7972	0.7118
PVIF @ 4%					0.8548	0.8219
PV ( Total cash flow x PVIF)	-40000000.00	3571428.57	3188775.51	2847120.99	3419216.76	19726250.56	-7247207.60

Thus NPV = -7247207.60 $