Question

2. Jane Summers has just inherited millions from her mother's estate. She is considering investing part of these funds in a small catering business. She would need to purchase a delivery van, equipment, and inventory costing $150,000 to equip the business. Jane's marketing studies indicate that the annual net cash inflow from the business will amount to $36,000. Jane wants to operate the catering business for only 6 years. She estimates that the equipment will have a $10,000 salvage value at the end of that time and that she will just retire and close down the business. Jane's required rate of return is 10%. (Note: relevant present value tables are in the textbook in ch 26 at pg 1121, or use from other sources, as desired.)

Required:
Compute the net present value of this investment. What would you advise Jane based on your calculations? Show your calculations, including any present value table amounts.

Answer 1

In these type of situations where the management is to decide whether to invest in the new asset or not , the best measure available to them is the calculation of Net Present Value.

Net present value calculates the net benefit/loss that will incur from the asset by calculating the present value of the inflows to be incurred or received by discounting them with the appropriate cost of capital.

Computation of Net Present Value:

Year	Annual flows	PV Factor@10%	NPV
	A	B	C=A*B
0	($150,000)	1	($150,000)
1	$36,000	0.90909	$32,727
2	$36,000	0.82645	$29,752
3	$36,000	0.75131	$27,047
4	$36,000	0.68301	$24,588
5	$36,000	0.62092	$22,353
6	$36,000	0.56447	$20,321
6	$10,000*	0.56447	$5,645
Net Present Value of Cash Inflows from Catering Business	$12,434

* Salvage Value

As the Net Present Value is positive it means that the new business will yield more returns than the cost of capital. Hence, Jane should make the investment in Catering Business.