Question

Your factory has been offered a contract to produce a part for a new printer. The contract would last for 3 years and your cash flows from the contract would be $4.75 million per year. Your upfront setup costs to be ready to produce the part would be $7.78 million. Your discount rate for this contract is 7.6%.

a. What does the NPV rule say you should​ do?

b. If you take the​ contract, what will be the change in the value of your​ firm?

Answer 1

Solution :

a. The NPV of the contract is = $ 4,550,103.70

= $ 4,550,104 ( when rounded off to the nearest whole number )

= $ 4.55 Million

As per the NPV Rule

1. If the NPV of the project is positive i.e., greater than zero, the contract should be accepted.

2. If the NPV of the project is negative i.e., less than zero, the contract should not be accepted.

Since the NPV of the project is = $ 4,550,104 ( $ 4.55 Million ) which is positive, as per the NPV Rule, the contract should be accepted.

b. If the contract is taken the change in the value of the firm is equal to the Value generated over and above the Initial Upfront cost of the contract =  The NPV of the contract.

Thus the change in the value of the firm = $ 4,550,104 = $ 4.55 Million

Please find the attached screenshot of the excel sheet containing the detailed calculation for the solution.