You are considering opening a new plant. The plant will cost$100 million upfront

Question

You are considering opening a new plant. The plant will cost$100 million upfront and will take one year to build. After that, it is expected to produce profits of $30 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 8%. 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

Cost of new plant: $100 million Expected cash flow: $ 30 million Cost of capital 8% Assumption: Let the cash flow lasts for 4 years NPV = (1 / 1 + cost of capital) (Cash flow / cost of capital) Initial flow NPV = (1/1.08)(30 / 0.08) 100 = 247.22 For, IRR, IRR = (1 / (1+ r))(cash flow/r) -100 = (1/(1+r)) (30/r) 100 = 0 IRR = 24.16% So, the cost of capital can be underestimated by 24.16% - 8% = 16.16% without changing the decision.

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