You are considering opening a new plant. The plant will cost $97.1 million up fr

Question

You are considering opening a new plant. The plant will cost $97.1 million up front and will take one year to build. After that it is expected to produce profits of $30.3 million at the end of every year of production. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 7.7%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

Explanation / Answer

NPV of a perpetuity is given by:

NPV = -Initial investment + Cashflow/rate

NPV = -97.1 + 30.3/0.077 = $296.41

Since the NPV is positive, we can make the investment.

- IRR is the rate at which NPV = 0

0 = -97.1 + 30.3/IRR

IRR = 31.20%

So the maximum deviation allowable = 31.20% - 7.7% = 23.50%

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