Question

Assume that a firm is considering building a factory that will cost $5 million. It believes that it can get a profit from this factory of $600,000 per year for many years. The interest rate at which the firm can borrow money is 15 percent. After evaluating whether it should build the factory, the firm decides that it should

Select one:

a. build

b. not build

Answer 1

Solution: not build

Given,

Initial investment = $5 million

Annual revenue = $600,000

Rate of interest (i) = 15% = 0.15

Since there is no time period mentioned, let us assume the time period to be infinity.

Therefore, n=

The Net Present Value = Initial Investment + (Annual cashflow x Present value factor)

= -$5000000 + {600,000 x (P/F, i, n)}

= -$5000000 + {600,000 x (P/F, 15%, )} [as (P/F, i, ) = 1/i ]

= -$5000000 + {600,000 x (1/0.15)}

= -$5000000 + (600,000 x 6.6667)

=  -$5000000 + 4,000,000

= -$1,000,000 = -$1 million

Based on the NPV analysis, it is observed tht the net present value of building the factory is a negative value. So, the firm should not move ahead with this factory and look for other alternatives. Incase, there are other options with negative NPVs greater than -$1 million, then ony this factory project should be taken up.