Question

The owners of a chain of​ fast-food restaurants spend $ 25 million installing donut makers in all their restaurants. This is expected to increase cash flows by $ 12 million per year for the next five years. If the discount rate is 6.6​%, were the owners correct in making the decision to install donut​ makers? Round answer to the nearest million.

Answer 1

As the NPV of the project is $25 million and is positive, the owners made a correct decision to install donut makers.

Step-by-step explanation:

An investment will add value when the Net Present Value of an investment is positive. The net Present Value (NPV) of an investment is the present value of all the future cash flows expected as a result of an investment less the initial cost of the project/investment.

As the cash flows from the investment will be a constant $12 million after equal intervals of time for a period of five years, this can be treated as an annuity and the NPV of the project can be calculated as the Present value of $12 million annuity less the initial cost of the investment of $25 million.

NPV = 12 * [ 1 - (1+0.066)^-5 / 0.066] - 25

NPV = $24.73 million or $25 million rounded off to the nearest million