Question

Your factory has been offered a contract to produce a part for a new printer. The contract would last for 3 years and your cash flows from the contract would be $5 million per year. Your upfront setup costs to be ready to produce the part would be $8 million. Your discount rate for this contract is 8%.

a. What does the NPV rule say you should​ do?

b.If you take the​ contract, what will be the change in the value of your​ firm?

c. Does the IRR rule agree with the NPV rule in this problem?

Answer 1

NPV = -8 + 5/(1.08) + 5/(1.08)² + 5/(1.08)³

NPV = $4.89 million

As per NPV rule project should be taken,

8 = 5/(1 + IRR) + 5/(1 + IRR)² + 5/(1 + IRR)³

IRR = 39.45%

As per IRR rule also, project should be taken.