Question

8. Project A: A factory costs $800,000. You reckon that it will produce an inflow after operating costs of $170,000 a year for 10 years. If the opportunity cost of capital is 14%. Project B: A machine costs $380,000 and is expected to produce the following cash flows:

If the cost of capital is 12%.

Answer 1

1. The NPV of project A is $86,720, while the NPV of project B is $23,750.

2. Based on the total NPV, the company should prefer project A to project B if they are exclusive.

The net present value (NPV) refers to the difference between the present value of cash inflows and the present value of cash outflows for a stated project or investment.

Project A:

Initial cost = $800,000

Annual net cash inflows = $170,000

Opportunity cost of capital = 14%

Number of years for the annual cashflows = 10 years

Annuity factor of 14% for 10 years = 5.216

PV annuity of $170,000 = $886,720 ($170,000 x 5.216)

Net Present Value (NPV) = $86,720 ($886,720 - $800,000)

Project B:

Cost of Machine = $380,000

Cost of capital = 12%

Present Value of Cash inflows:

Period Cashflows PV factor Present Value

Year 1 $50 0.893 $44.65

Year 2 $57 0.797 $45.43

Year 3 $75 0.712 $53.40

Year 4 $80 0.636 $50.88

Year 5 $85 0.567 $48.20

Year 6 $92 0.507 $46.64

Year 7 $92 0.452 $41.58

Year 8 $80 0.404 $32.32

Year 9 $68 0.361 $24.55

Year 10 $50 0.322 $16.10

Total present value = $403.75

Net present value = $23,750 (403,750 - $380,000)

Question Completion:

What is the NPV of each project? Which project should the company proceed with?