Company VGG is thinking of buying a factory to meet the growing demand for its p

Question

Company VGG is thinking of buying a factory to meet the growing demand for its products. The following is the financial data regarding this proposal.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

Cost of the factory today                         $20 million

Annual cash flow                                       $2 million

Life of the factory                                      15 years

Cost of capital                                             8%

1.     CALCULATE THE FOLLOWING:

a.     Payback period in years

b.     Net present value.

2.     Based on your answer for 1.b above, should the company buy this factory? Why or why not?

3.     Bonus: 5 points

Now assume that after 15 years, the factory can be sold for $12 million. What is the net present value?

Explanation / Answer

Hi,

Please find the answer as follows:

Part 1:

Payback Period = 20/2 = 10 years

NPV = - 20000000 + 2000000/(1+.08)^1 + 2000000/(1+.08)^2 + 2000000/(1+.08)^3 + 2000000/(1+.08)^4 + 2000000/(1+.08)^5 + 2000000/(1+.08)^6 + 2000000/(1+.08)^7 + 2000000/(1+.08)^8 + 2000000/(1+.08)^9 + 2000000/(1+.08)^10 + 2000000/(1+.08)^11 + 2000000/(1+.08)^12 + 2000000/(1+.08)^13 + 2000000/(1+.08)^14 + 2000000/(1+.08)^15 = -2881042.62 or -2881043

Part 2:

No, the factory should not be bought as it is resulting in a negative NPV.

Part 3:

NPV = - 20000000 + 2000000/(1+.08)^1 + 2000000/(1+.08)^2 + 2000000/(1+.08)^3 + 2000000/(1+.08)^4 + 2000000/(1+.08)^5 + 2000000/(1+.08)^6 + 2000000/(1+.08)^7 + 2000000/(1+.08)^8 + 2000000/(1+.08)^9 + 2000000/(1+.08)^10 + 2000000/(1+.08)^11 + 2000000/(1+.08)^12 + 2000000/(1+.08)^13 + 2000000/(1+.08)^14 + 2000000/(1+.08)^15 + 12000000/(1+.08)^15= 901857.84 or 901858

Thanks.

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