Question

Wachowicz Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after the 4thyear. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if the cost of capital is 10%, by what amount will the better project increase the firm's value?

Answer 1

Answer:

Process S gives a higher net present value

1,237.46 againnst 1,179.46 of process L

It will add a value of 1,237.46

Explanation:

We will calcualte each process present value at the given rate

Process S

The project will last 4 year so the machine will be purchased 2 times

one at the beginning and another at the beginning of the third yar

cash flow 5,000 for 4 year at 10%

$C \times \frac{1-(1+r)^{-time} }{rate} = PV$

C 5000

time 4

rate 0.1

$5000 \times \frac{1-(1+0.1)^{-4} }{0.1} = PV$

PV $15,849.33

Now the present value fo the second machine purchased

$\frac{Maturity}{(1 + rate)^{time} } = PV$  

Maturity   (8,000.00)

time   2.00

rate   0.10

$\frac{-8000}{(1 + 0.1)^{2} } = PV$  

PV   (6,611.57)

NPV = 15,849.33 - 8,000 - 6,611.57 = 1,237.36

Now the next, process L

This time we don't need to purchase a new machine.

$C \times \frac{1-(1+r)^{-time} }{rate} = PV$

C 4000

time 4

rate 0.1

$4000 \times \frac{1-(1+0.1)^{-4} }{0.1} = PV$

PV $12,679.46

NPV 12,679.46 - 11,500 = 1,179.46