Question

Smith Machining Corp. is a small business considering investing in one of 2 new product production lines. However, they can only afford to do one of the projects. The development and implementation of either project will take a year and the initial cash outlay will be $1,500,000 if they take a traditional bank loan at 10%. If they pursue a Small Business Association (SBA) guaranteed loan through their bank, the rate on the loan will be 7% however, they will need to pay an up-front fee of 10% of the net proceeds of their loan, which can be added to the loan. The projects have the following projected net cash flows:

Year	Project A	Project B
1	$         250,000	$         100,000
2	$         250,000	$         100,000
3	$         250,000	$         100,000
4	$         500,000	$         100,000
5	$         500,000	$         100,000
6	$         250,000	$         400,000
7	$         100,000	$         750,000
8	$            50,000	$         750,000
9	$            50,000	$      1,000,000

1. Calculate and show the NPV of each project at the 10% rate
2. Calculate and show the NPV of each project at the 7% SBA loan rate
3. Which project would you choose, A or B and why?
4. Does the SBA loan improve the result and would you recommend getting the SBA loan even with the added 10% cost? Why or why not?

Answer 1

Net Present Value(NPV) is the difference between the present value of cash inflows and the present value of cash outflows. It is used in evaluating capital budgeting decisions. Projects with NPV greater than 0 are investable.

a) NPV of projects at 10% rate.

We can calculate NPV in excel,

	Cashflows		Discounted cash flows
Yr	A	B	Discount factor @ 10%	A	B
0	-1500000	-1500000	1.000	-1500000.0	-1500000.0
1	250000	100000	0.909	227272.7	90909.1
2	250000	100000	0.826	206611.6	82644.6
3	250000	100000	0.751	187828.7	75131.5
4	500000	100000	0.683	341506.7	68301.3
5	500000	100000	0.621	310460.7	62092.1
6	250000	400000	0.564	141118.5	225789.6
7	100000	750000	0.513	51315.8	384868.6
8	50000	750000	0.467	23325.4	349880.5
9	50000	1000000	0.424	21204.9	424097.6
			NPV	10,644.9	263,715.0

NPV for project A = $10,644.9

NPV for project B = $263,715

Project B has a higher NPV, hence it is preferable.

b) NPV of project at 7% rate and additional initial cost.

	Cashflows		Discounted cash flows
Yr	A	B	Discount factor @ 7%	A	B
0	-1650000	-1650000	1.000	-1650000	-1650000
1	250000	100000	0.935	233644.9	93457.9
2	250000	100000	0.873	218359.7	87343.9
3	250000	100000	0.816	204074.5	81629.8
4	500000	100000	0.763	381447.6	76289.5
5	500000	100000	0.713	356493.1	71298.6
6	250000	400000	0.666	166585.6	266536.9
7	100000	750000	0.623	62275.0	467062.3
8	50000	750000	0.582	29100.5	436506.8
9	50000	1000000	0.544	27196.7	543933.7
			NPV	29,177.4	474,059.5

NPV for project A = $29,177.4

NPV for project B = $474,958.5

Project B has a higher NPV, hence it is preferable.

c) Which project would you choose, A or B and why?

We will select Project B as in both the cases the NPV of Project B is greater than Project A.

d) Does the SBA loan improve the result?

Yes the SBA loan improves the NPV of both the projects. Even with an additional 10% cost, the NPV of both projects increases significantly, and hence taking a SBA loan is beneficial to the organization and the project must be financed through SBA loan to get a higher NPV.

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