Question

Basic Net Present Value Analysis

Windhoek Mines, Ltd., of Namibia, is contemplating the purchase of equipment to exploit a mineral deposit on land to which the company has mineral rights. An engineering and cost analysis has been made, and it is expected that the following cash flows would be associated with opening and operating a mine in the area:

The mineral deposit would be exhausted after four years of mining. At that point, the working capital would be released for reinvestment elsewhere. The company’s required rate of return is 20%.

Required:

Determine the net present value of the proposed mining project. Should the project be accepted? Explain.

Answer 1

Net Present Value (NPV)

The discounted amount of the future cash inflows deducted from the current cash outflows is known as net present value.

Compute NPV of the equipment.

Step 1: Calculate total cash inflows:

It is given that the annual cash flow is $120,000, working capital released is $100,000, salvage value is $65,000, and road construction is $40,000. Now, calculate the total cash flows as shown below:

Particulars	Cash Outflows ($)	Cash Inflows ($)
	Year-0	Year-1	Year-2	Year-3	Year-4
Cost of equipment	(275,000)
Working capital required	(100,000)
Annual net cash receipts		120,000	120,000	120,000	120,000
Cost of construction of new roads (3 years)				(40,000)
Salvage value (4 years)					65,000
Working capital released (4 years)					100,000
Total cash flows	(375,000)	$120,000	$120,000	$80,000	$285,000

Step 2: Calculate net present value.

Years	Details	Net Cash Inflow		Annuity PV Factor (i =20%)	=	Present Value
0	Cost of equipment	$(275,000)		1	=	$(275,000)
0	Working capital required	(100,000)		1	=	(100,000)
1	Net cash receipts	120,000		0.833	=	99,960
2	Net cash receipts	120,000		0.694	=	83,280
3	Net cash receipts	80,000		0.579	=	46,320
4	Net cash receipts	285,000		0.482	=	137,370
	NPV	$(8,070)

Hence, the net present value is .

Decision for acception or rejection of project:

Accept or reject criteria: If the NPV is positive or greater than zero, accept the project else reject.

Decision: The NPV is negative which means that the rate of return on the equipment is less than 20% of company’e desired rate of return. Hence, the equipment should not be purchased.