Mirar Vision Clinic is considering an investment that required an outlay of $400
ID: 2416026 • Letter: M
Question
Mirar Vision Clinic is considering an investment that required an outlay of $400,000 and promises a net cash inflow one year from now of $540,000. Assume the cost of capital is 10 percent.
Required:
1. Break the $450,000 future cash inflow into three components:
a. The return of the original investment
b. The cost of capital
c. The profit earned on the investment
2. Now, compute the present valie of the profit earned on the investment.
3. Compute the NPV of the investment. Compare this with the present value of the profit computed in requirement 2. What does this tell you about the meaning of NPV?
Explanation / Answer
Note: The cash flow for year one is at first stated as $540,000 and under Requirement (1) as $450,000.
If it is $540,000, the answers are:
1) Break up is
a) Return of Original investment = $400,000
b) Cost of Capital =400000*0.1 = 40,000
c) Profit earned on the investment = 100,000
2) Present Value of the Profit earned on the investment = 100000/1.1 = $90,909
3) NPV of the Investment = (540000/1.1) - 400000 = 490909 - 400000 = $90,909
As answers under (2) & (3) are the same, it means that NPV is nothing but the present value of the profit after covering the cost of capital and original investment. Thus, the NPV of a project represents the addition to the shareholders wealth in present value terms, if the project is undertaken. (If NPV is negative it means that the shareholders' would decline to that extent, in PV terms)