Question

Year	1	2	3	4	5	6
High Demand (50%) After-tax cash flows	500,000	700,000	1,000,000	1,300,000	1,400,000	1,000,000
Low Demand (50%) After-tax cash flows	100,000	100,000	100,000	100,000	100,000	100,000
Weighted average after-tax cash flow	300,000	400,000	550,000	700,000	750,000	550,000

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The equipment to make full-size greenhouse kits – 16 feet and 22 feet in diameter – would cost about $2.5 million. If the company closes down early the after-tax cash-flow from the sale of the equipment will be $900,000 at the end of Year 1 and $650,000 at the end of Year 2. It has no resale value beyond Year 2.

The table shows projected cash flows for high and low demand scenarios. The cash flows include depreciation, taxes, etc. The only thing missing is the salvage value of the equipment if the project is abandoned early.

A. Compute the traditional NPV of the project using a 10% discount rate.

B. Compute the NPV of the project using a 10% discount rate and assuming that if demand is low that the company can be shut down after Year 1 or Year 2, whichever is best.

C. Should they make this investment?

Answer 1

We can calculate NPV by using {(High demand Cash flows * Probability 50%) + (Low Demand Cash flows * Probability 50%)} * Discount rate @ 10% or Weighted average cash flows * Discount rate @ 10%.

Hence we can take Weighted average cash flows.

A. Calculating NPV: Weighted Avg After-tax Discount rate @10% = Year cash flows (1/1+10%)^n 300,000 0.90909091 400,000 0.82644628 550,000 0.75131480 700,000 0.68301346 750,000 0.62092132 550,000 0.56447393 Total Present value cash flows Less: Equipement Cost Net Present value (NPV) Present Value in $ (Cashflows * Disc. Rate) 272,727.27 330,578.51 413,223.14 478,109.42 465,690.99 310,460.66 2,270,790.00 (2,500,000.00) (229,210.00)

B. Calculating NPV with low demand: Low Demand After-tax Discount rate @10% = Year cash flows (1/1+10%)^n 100,000 0.90909091 100,000 0.82644628 Present Value (Cashflows * Disc. Rate) 90,909.09 82,644.63 If Shut down after 1 Year Present Value cashflows Equipment sale value Amount in $ 90,909.09 900,000.00 990,909.09 (2,500,000.00) (1,509,090.91) Less: Equipement Cost Net Present value (NPV) If Shut down after 2 Years Amount in $ Present Value cashflows: 1 Year 90,909.09 2 Year 82,644.63 173,553.72 Equipment sale value 650,000.00 823,553.72 (2,500,000.00) (1,676,446.28) Less: Equipement Cost Net Present value (NPV) It is better to Shut down after 1 year then the 2 years.

C. By looking into the NPV calculated in point A, showing negative NPV of $229,2210. Hence it is better not to invest in this Equipment.