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

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

NPV: cost of capital = 8%.

At point 0, cash outflow will be $100 million. The present value of this outflow will also be $100 million.

The project will be completed at the start of year 1 and will give a cash inflow of $30 million starting from end of year 1. This is an ordinary annuity or a deferred annuity.

Its present value will be = amount/cost of capital = $30 million/0.08 = $375 million

NPV = PV of inflows - PV of outflows

= $375 million - $100 million = $275 million. As the NPV>0, we should make this investment.

IRR: It is the discount rate which makes the NPV as zero. Let it be "x"

so, 30/x - 100 = 0

30/x = 100

or x = 0.30 or 30%.

IRR>cost of cost of capital, for leaving the decision unchanged.

so, cost of capital can go upto a maximum of 29.99%.

maximum deviation allowed = 29.99 - 8 = 21.99%

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