Question

Transcendental Advisors is advising one of their corporate clients on potential investment opportunities. The advisors are presented with two business strategies (a and b below). The company expects the profit to be $2,000,000 a year with no growth. The company also operates tax-exempt and is subject to 8.6% p.a. cost of capital compounded annually. The company long-term borrowing rate is 5.9% p.a. compounded annually. a) Spend $5,000,000 to expand existing operations, boosting current expected annual profit from $2,000,000 to $3,000,000. b) Spend $10,000,000 on lobbying and sign an exclusive contract with the government, who guarantees to purchase all of the company’s products for $2,500,000 a year but prohibits the company from selling anything to the existing customer base. Which investment opportunity is better? Show your work. (assume the client company operates perpetually).

Answer 1

Since the Company operates in perpetuity, NPV has to be Calculated for perpetuity

That is

NPV = (Expected Annual Profit - Interest on Initial Outlay) / (Cost of Capital - growth) - Initial Outlay

Cost of Capital = 8.6%

Growth = 0%

Scenario A

Expected Annual Profit		30,00,000.00
Cost of Capital		8.60%
Initial Outlay		50,00,000.00
Annual Interest %		5.90%
Annual Interest on Initial Outlay		2,95,000.00
Net Annual Profit (Profit - Interest)		27,05,000.00
Present Value (Profit/Cost of capital)		314,53,488.37
(Less) Initial Outlay		50,00,000.00
Net Present Value		264,53,488.37

NPV = $ 26,453,488.37

Scenario B

Here the Government guaruntees to purchase all products and no outside sales are allowed Expected Annual Profit is at $ 2,500,000.00.

Expected Annual Profit		25,00,000.00
Cost of Capital		8.60%
Initial Outlay		100,00,000.00
Annual Interest %		5.90%
Annual Interest on Initial outlay		5,90,000.00
Net Annual Profit (Profit - Interest)		19,10,000.00
Present Value (Profit/Cost of capital)		222,09,302.33
(Less) Initial Outlay		100,00,000.00
Net Present Value		122,09,302.33

NPV = $ 12,209,302.33

Conclusion: Since NPV in Scenario A is Higher than NPV in Scenarion B, Scenario A is a better Opportunity