Anderson International Limited is evaluating a project in Erewhon. The project w

Question

Anderson International Limited is evaluating a project in Erewhon. The project will create the following cash flows:

All cash flows will occur in Erewhon and are expressed in dollars. In an attempt to improve its economy, the Erewhonian government has declared that all cash flows created by a foreign company are “blocked” and must be reinvested with the government for one year. The reinvestment rate for these funds is 7 percent. Assume Anderson uses a required return of 12 percent on this project.

What is the NPV of the project?

Year Cash Flow 0 –$586,000    1 216,000    2 159,000    3 224,000    4 203,000   

Explanation / Answer

The NPV of the project is calculated as follows:

Since the funds are being reinvested at 7% and the rate of return is 12%, the effective discount rate is 12-7 =5%

The NPV calculation is as shown below:

Year Cash flow Discounted Cash flow at 5% 0 -586000 -586000 1 216000 205714.2857 2 159000 144217.6871 3 224000 193499.6221 4 203000 167008.6024 NPV $                               124,440.20

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