In: Finance
Digitel Electronics’ engineering and marketing departments have prepared forecasts for the development costs and operating profits of the next generation of their digital electrical meters. Development costs for each of the next three years will be $50,000.Manufacturing equipment costing $100,000 will be purchased near the end of Year 3. Annual profits for the normal five-year product life (Years 4 to 8 inclusive) are projected to be $80,000. The salvage value of the manufacturing equipment at the end of Year 8 is $20,000. Use NPV as your selection criteria. Should Digitel proceed with the product development if its annually compounded cost of capital is: a. 14%? b. 17%?
To decide whether the project is a good investment to undertake or not, we need to calculate the net present value (NPV) of project.
NPV is the sum of present value of all cash flows
If NPV is greater than zero then company should undertake this project as it is creating value for the company
To calculate the present value (PV) of a cash flow, we need to discount it by the required return.
PV = CFn/(1+r)n,
where CFn is cash flow in period n, r is required rate of return, n is time period
NPV = CF0 + CF1/(1+r)1 + CF2/(1+r)2 + ................... + CFn-1/(1+r)n-1 + CFn/(1+r)n
r is cost of capital in this case, as company will require to return at least cost of capital to generate value form this project.
Development cost in each of year 1, 2 and 3 = $50,000
Cost of manufacturing equipment = $100,000
Annual profits from year 4 to 8 = $80,000
Salvage value of manufacturing equipment = $20,000
So, cash flow in year 1 i.e. CF1 = $-50,000, negative sign indicates cash outflow
CF2 = $-50,000
CF3 = -50,000-100,000 = $-150,000
CF4 = $80,000
CF5 = $80,000
CF6 = $80,000
CF7 = $80,000
CF8 = $80,000+20,000 = $100,000
a) Cost of capital = 14%
Now putting all the values in NPV equation
NPV = -50,000/(1+0.14)1 - 50,000/(1+0.14)2 - 150,000/(1+0.14)3 + 80,000/(1+0.14)4 + 80,000/(1+0.14)5 + 80,000/(1+0.14)6 + 80,000/(1+0.14)7 + 100,000/(1+0.14)8
Solving this we get NPV as $8,810.98
As NPV > 0, therefore we should proceed with the development
b) Cost of capital = 17%
Now putting all the values in NPV equation
NPV = -50,000/(1+0.17)1 - 50,000/(1+0.17)2 - 150,000/(1+0.17)3 + 80,000/(1+0.17)4 + 80,000/(1+0.17)5 + 80,000/(1+0.17)6 + 80,000/(1+0.17)7 + 100,000/(1+0.17)8
Solving this we get NPV as $-7,414.45
As NPV < 0, therefore we should not proceed with the development