Question

Suppose an opportunity arises to invest $10 million that will pay $5.5 million at the end of year 1 and $6.5 million at the end of year two. The cost of capital is 10%.

Find NPV. Is the project a go? Show and explain
Suppose the project’s cash flows are delayed a year, but not the outlay. How does that change your answer? Show and explain
Suppose there is a cost overrun of 20%. The cash flows and their timing are the same as in part a. How does this change your answer? Show and explain.
Suppose the second-year cash flow decreases to $5 million. The outlay and timing of the cash flows are the same as in part a. How does this change your answer? Show and explain.
Evaluate the proposal. Would you undertake it?

Answer 1

The Net Present Value (NPV) of the project is -$136,363.64. With a negative NPV, the project is not financially viable at a cost of capital of 10%.

Explanation:

The NPV calculation involves discounting the future cash flows to their present value using the cost of capital. For this scenario, the cash flows are $5.5 million at the end of year 1 and $6.5 million at the end of year 2. Using the formula for NPV calculation, the present value of these cash flows amounts to -$136,363.64 at a 10% cost of capital. A negative NPV indicates that the project's returns are lower than the cost of capital, leading to value destruction for the investor.

This project should not be pursued as it fails to generate positive value for the investment at the specified cost of capital.

Delaying the cash flows by a year without delaying the initial outlay affects the NPV calculation. The present value of future cash flows decreases due to the additional discounting year, potentially further reducing the project's viability.

A 20% cost overrun would increase the initial outlay to $12 million. This increased investment without a proportional increase in returns would significantly impact the NPV, likely making the project even less feasible, as the returns remain the same while the initial investment rises.

Reducing the second-year cash flow to $5 million affects the future cash inflow, decreasing the total returns. This would lower the NPV further, making the project even less attractive from an investment perspective.

In summary, the NPV analysis indicates that the project, under various scenarios, fails to meet the required return of the cost of capital, thus rendering it unsuitable for investment.