#4: FAMILY BUSINESS EXAMPLE You own a family business with net worth of $250,000
ID: 1144503 • Letter: #
Question
#4: FAMILY BUSINESS EXAMPLE You own a family business with net worth of $250,000. You can purchase a machine costing $200,000 today (11/8/14) . If the market for the output remains strong, you will receive the following revenue stream (assume no additional costs): Revenue $80,000 $80,000 $80,000 $80,000 $80,000 Date 11/10/15 11/10/16 11/10/18 11/10/19 At the end of the period, the machine will have re-sale value of $1,000 (scrap metal). If the market is weak, you will receive the following revenue stream (assume no additional costs):Explanation / Answer
In the given scenario, there are two economic conditions named as strong and weak economic conditions with different cash inflows. In this regard, there needs a probability data of the happening of the strong or weak economic conditions. On the basis of it, expected value of cash inflows for each year is calculated. In the given case, probability information is not given then equally likely criteria or .5 probability for each of the two economic conditions will be used.
On this basis,
Expected value of cash inflows per year (for the 5 years) = .5*80000 + .5*30000
Expected value of cash inflows per year (for the 5 years) = $55000
Salvage value after 5 years (resale value) = $1000
Afterwards, the net present worth of the investment will be calculated by using the following formula.
Net present worth = Present value of expected cash inflows + present value – initial investment
If discount rate = R
Time = 5 years
Net present worth = 55000*(1-1/(1+R)^5)/R + 1000/(1+R)^5 – 200000
If net present worth is positive, then project should be accepted. If net present worth is negative, then project should be rejected.
The additional information required is the discount rate R. It should be based upon risk free rate, market risk premium, and or prevailing inflation rates.
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