Question

A six-year project has an initial cost of $10 million with an expected revitalization cost of $4 million in Year 5. Inflows of $4 million are expected in Year 2 through to Year 5, and $5 million is expected in Year 6. The cost of capital for this project is 13% compounded annually. Should this project be launched?

Answer 1

The Net Present Value (NPV) method is used to determine whether a project should be launched. Calculating the NPV involves discounting future cash flows to present value. In this case, the NPV is negative, indicating that the project should not be launched.

Step-by-step explanation:

The Net Present Value (NPV) method can be used to determine whether a project should be launched. To calculate the NPV, we need to discount the future cash flows of the project to present value by using the cost of capital. Here is the step-by-step calculation:

1. Calculate the present value of the initial cost: $10 million / (1 + 0.13)0 = $10 million
2. Calculate the present value of the project's inflows: $4 million / (1 + 0.13)2 + $4 million / (1 + 0.13)3 + $4 million / (1 + 0.13)4 + $5 million / (1 + 0.13)5 = $11.66 million
3. Calculate the present value of the revitalization cost: $4 million / (1 + 0.13)5 = $2.46 million
4. Calculate the net present value (NPV): NPV = present value of inflows - present value of initial cost - present value of revitalization cost = $11.66 million - $10 million - $2.46 million = $-0.8 million

The NPV of -$0.8 million indicates that the project is expected to generate a negative return. Therefore, this project should not be launched as the present value of the expected cash inflows is less than the initial cost and the revitalization cost.