8.13 A new plant to produce tractor gears requires an initial investment of $10

Question

8.13 A new plant to produce tractor gears requires an initial investment of $10 million. It is expected that a supplemental investment of $4 million will be needed every 3 years to update the plant. The plant is expected to start producing gears 2 years after the initial investment is made (at the start of the third year). Revenues of S5 million per year are expected to begin to flow at the start of the fourth year. Annual operating and maintenance costs are expected to be $2 million per year. The plant has a 15-year life. List the annual cash flows. Ans. CFo =-$ 10 000 000, CF,-CF2-0, CF,--$6 000 000, CF,-CFs = CF,-CF,-CFi,-CFI,- CF,,-CF14 = $3 000 000, CF,-CF,-CF,,-CF15=-$1 000 000 What is the NPV of the plant in Problem 8.13 if the interest rate is 10% per year, compounded annually? Ans. -$5 336 645.33 8.14 Is the plant described in Problems 8.13 and 8.14 an economically acceptable investment? Ans. 8.15 No, because the NPV is negative

Explanation / Answer

The production starts in year 3, CF3 would include the maintenance and operation and the supplemental investment costs = 4 + 2 = $6 mn

Every 3rd year Cashflow = 5 - 2 - 4 = -$1 mn, for all the remaining years cashflow = 5 - 2 = $3 mn

1)

NPV ($ mn)= -10 -6/1.12 + 3/1.13 + .. -1/1.16 + 3/1.17 + ..... -1/1.115

NPV = - $5336583.92

2)

NPV is negative, hence, the present value of costs > present value of benefits. It is therefore, not an economically acceptable investment.

Year CF ($ mn) 0 -10 1 0 2 0 3 -6 4 3 5 3 6 -1 7 3 8 3 9 -1 10 3 11 3 12 -1 13 3 14 3 15 -1

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