Question

Read the scenario.

You are the financial manager of a firm that is contemplating investing $25,000 in a new project that you expect will generate cash flows of $10,000 per year for five years and then $15,000 per year for another two years. At the end of seven years you expect to sell the project's assets for $50,000. You believe that you should earn at least 14% to compensate the shareholders for the project's risk.

• Explain the process for evaluating this project.
• What is the present value of the project's terminal value?

Answer 1

The process for evaluating this project will be to calculate the net present value. If the NPV is positive we shall accept the project and if the NPV is negative, we shall reject the project.

The NPV will be computed as shown below:

= - $ 25,000 + $ 10,000 / 1.14¹ + $ 10,000 / 1.14² + $ 10,000 / 1.14³ + $ 10,000 / 1.14⁴ + $ 10,000 / 1.14⁵ + $ 15,000 / 1.14⁶ + $ 15,000 / 1.14⁷ + $ 50,000 / 1.14⁷

= $ 42,141.03

Since the NPV is positive, hence we shall accept the project

The present value of the project's terminal value will be as follows:

= $ 50,000 / 1.14⁷

= $ 19,981.87 Approximately

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