Question

Corporation is a rapidly growing biotech company that has a required rate of return of 14​%. It plans to build a new facility in Santa Clara County. The building will take 2 years to complete. The building contractor offered New Pharm a choice of three payment​ plans, as​ follows:

Plan I: Payment of $ 325,000 at the time of signing the contract and $ 4,825,000 upon completion of the building. The end of the second year is the completion date.
Plan II: Payment of $ 1,675,000 at the time of signing the contract and $ 1,675,000 at the end of each of the 2 succeeding years.
Plan III: Payment of $ 425,000 at the time of signing the contract and $ 1,650,000 at the end of each of the 3 succeeding years.
Required
1. Using the net present value method, calculate the comparative cost of each of the three payment plans being considered by New Tech.
2. Which payment plan should New Tech choose? Explain.
3. Discuss the financial factors, other than the cost of the plan, and the non-financial factors that should be considered in selecting an appropriate payment plan.

Answer 1

NPV = $4,037,680.83

NPV = $4,433,156.36

NPV = $4,255,692.85

The first payment plan would be chosen because it has the lowest NPV. If chosen, the lowest amount would be paid.

Expected inflation: if inflation is expected to rise higher than expected in subsequent years , payment plans that differ payment to later year might be more suitable . Inflation causes the value of money to fall so if payment is made in later years , less money would be paid.

Conversely, if inflation is expected to fall, payment plan that makes payments in earlier years would be more suitable.

Also, the effect of payment on other projects should be considered. For example, if the company has other projects they want to undertake now but do not have enough capital required to start, the company might want to choose a payment plan that differs payment especially if the other project doesn't have a flexible payment plan.

Step-by-step explanation:

Net present value is the present value of after tax cash flows from an investment less the amount invested.

NPV can be calculated using a financial calculator

Plan 1

Cash flow in year 0 = $ 325,000

Cash flow in year 1 = 0

Cash flow in year 2 = $ 4,825,000

I = 14%

NPV = $4,037,680.83

Plan 2

Cash flow each year from year 0 to 2 = $1,675,000

I = 14%

NPV = $4,433,156.36

Plan 3 :

Cash flow in year 0 = $ 425,000

Cash flow each year from 1 to 3 = $ 1,650,000

I = 14%

NPV = $4,255,692.85

To find the NPV using a financial calacutor:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. After inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.

3. Press compute

I hope my answer helps you