Question

your factor has been offered a contract to produce a part for a new printer. the contract would be for 3 years and your cash flow from the contract would be 5 million per year. Your up-front setup costs to be ready to produce the part would be 8 million. Your cost of capital for this contract is 8%

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?

c. Does the IRR rule agree with the npv rule?

Answer 1

Requirement (a)-Net Present Value (NPV) of the Project

Net Present Value (NPV) of the Project = Present Value of annual cash inflows – Present Value of outflows

= [CF1/(1 + r)¹ + CF2/(1 + r)² + CF3/(1 + r)³] – Initial Investment

= [$5.001/(1 + 0.08)¹ + $5.00/(1 + 0.08)² + $5.00/(1 + 0.08)³] – $8.00

= [($5.00 / 1.08) + ($5.00 / 1.16640) + ($5.00 / 1.25971)] - $8.00

= [$4.63 + $4.29 + $.97] - $8.00

= $12.89 - $8.00

= $4.89 Million

“The Net Present Value (NPV) of the Project = $4.89 Million”

Here, the Net Present Value (NPV) method says that you should take the contract, since it has the positive NPV of $4.89 Million”

Requirement (b)-Change in the value of the firm

If we take the contract, then the Change in the value of the firm would be $4.89 Million.

Requirement (c) – “YES” The IRR Rule agrees with the NPV Rule, since the Net Present Value (NPV) of the proposed contract is positive $4.89 Million”