Hi there, I need help with these questions. Please use formulas when applicable.

Question

Hi there, I need help with these questions. Please use formulas when applicable. Thanks.

When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2009, and the equipment necessary for producing the containers was being sold for $700K. Each year, this cost is expected to increase by 20%. The useful life of the equipment and the project is 5 years. Mr. Johnson estimated that during a good year, the project will generate net cash flows of $500K per year, while during a bad year, the project will lose money, with an expected net cash flow of $-100K per year.

What is the Present Value of this project?

Explanation / Answer

Cash outflow in 2009 = $700k

It is estimated that during a good year net cash flows = $500k and during bad year the project will lose money by $-100k

Now, various assumptions are possible such as first year will be bad year and thereafter all 4 years will be good years or there will be alternative good and bad years or various other assumption

I am assuming that the probability of both good &bad year will be equal i.e. 0.5 and therefore net cash flow per year would be ($500k * 0.5) + ($-100k * 0.5) = $200k

Since each year cost of equipment will increase by 20% we will consider discounting all future flows at 20%

PV of cash inflows

Year 1 to Year 5 = $200k * Annualised Discounting factor for 5 years of 20% = $200k * 2.990612135 = $598122.427

NPV = $598122.427 - $700000 = -$101877.573

These assumption gives negative NPV

Now, let us assume that in intial two years will be bad years and the remaining 3 years will be good years,

PV of cash inflow

Year 1 = $-100000 * 0.8333 = -$83333.333

Year 2 = -$100000 * 0.694444 = -$69444.4444

Year 3 = $500000 * 0.578703703 = $289351.8515

Year 4 = $500000 * 0.482253085 = $241126.5425

Year 5 = $500000 * 0.40187757 = $200938.785

Total PV of cash inflow = $578639.4016

These assumption also gives negative NPV ($578639.4016-$700000 = $121360.5984)

NOw if we assume first 3 years good years and remaining 2 years as bad years

Year 1 = $500000 * 0.8333 = $416666.6665

Year 2 = $500000 * 0.694444 = $347222.222

Year 3 = $500000 * 0.578703703 = $289351.8515

Year 4 = -$100000 * 0.482253085 = -$48225.3085

Year 5 =-$100000 * 0.40187757 = -$40187.757

PV of cash inflow = $964827.674

These assumption gives positive NPV i.e. $264827.674 ($964827.674 - $700000)

Thus, various other assumption will provide various NPV's if the management expects good years in the intial years then the projectshould be accepted if management expects bad years in the initial years then it should not be accepted

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