Stay Swift Corp. is looking at investing in a production facility that will requ
ID: 2764700 • Letter: S
Question
Stay Swift Corp. is looking at investing in a production facility that will require an initial investment of $500,000. The facility will have a three-year useful life, and it will not have any salvage value at the end of the project’s life. If demand is strong, the facility will be able to generate annual cash flows of $260,000, but if demand turns out to be weak, the facility will generate annual cash flows of only $130,000. Stay Swift Corp. thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.
If the company uses a project cost of capital of 12%, what will be the expected net present value (NPV) of this project?
-$20,568
-$31,643
-$22,150
-$26,897
Points:
Close Explanation
Explanation:
Stay Swift Corp. could spend $510,000 to build the facility. Spending the additional $10,000 on the facility will allow the company to switch the products they produce in the facility after the first year of operations if demand turns out to be weak in year 1. If the company switches product lines because of low demand, it will be able to generate cash flows of $255,000 in years 2 and 3 of the project.
What is the expected NPV of this project if Stay Swift Corp. decides to invest the additional $10,000 to give themselves a flexibility option?
$33,724
$75,880
$47,401
$52,668
Points:
Close Explanation
Explanation:
What will be the value of Stay Swift Corp.’s flexibility option? selector 1
Explanation / Answer
Answer:
Calculation of Net Present Value :
Year
Cash Inflow/ Outflow
Discount Rate
0
(500,000)
1
243,333 (260,000-16667)
(1+0.12)^1
2
178,333 (195,000-16667) (260,000/2)+(130,000)/2 (this is because of being fifty percent strong and fifty percent weak , hence 195,000 is arrived at)
(1+0.12)^2
3
113,333 (130,000-16667)
(1+0.12)^3
Depreciation value= $500,000 /3 years = $16,667/-
Here, as the cash inflows are uneven:
NPV =
R1
+
R2
+
R3
+ ...
Initial Investment
(1 + i)1
(1 + i)2
(1 + i)3
In the above formula,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period.
Therefore, Net Present Value = 440,095.77 – 500,000
Net Present Value = (-59,904.23)
Year
Cash Inflow/ Outflow
Discount Rate
0
(510,000)
1
130,000
(1+0.12)^1
2
255,000
(1+0.12)^2
3
255,000
(1+0.12)^3
Here, as the cash inflows are uneven:
NPV =
R1
+
R2
+
R3
+ ...
Initial Investment
(1 + i)1
(1 + i)2
(1 + i)3
In the above formula,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period.
Therefore, Net Present Value = 500,859.83 – 510,000
Net Present Value = (-$9,140.17)
Year
Cash Inflow/ Outflow
Discount Rate
0
(500,000)
1
243,333 (260,000-16667)
(1+0.12)^1
2
178,333 (195,000-16667) (260,000/2)+(130,000)/2 (this is because of being fifty percent strong and fifty percent weak , hence 195,000 is arrived at)
(1+0.12)^2
3
113,333 (130,000-16667)
(1+0.12)^3