Question

VOTD Pharmaceuticals is considering the mass production of a new sleeping pill. Neely O’Hara, VOTD’s financial analyst, has gathered all the available information from the finance, production, advertising, and marketing departments and has estimated that the yearly net incremental cash flows will be $298,500. She estimates the initial investment for this project will be $2 million. The pills are expected to be marketable for 10 years, and Neely does not expect that any of the investment costs will be recouped at the end of the 10-year period. VOTD’s required rate of return for average-risk projects is 8 percent. Two percent is added to the required rate of return for high-risk projects. Calculate the net present value of the project if VOTD management considers it to be of average risk. Enter your answer rounded to the nearest whole dollar. $

Answer 1

NPV of the project = $2,959

Required rate of return for the given project is 8%. (Since the project is considered to be of average risk)

	Net incremental cash flow ($)	Present Value of 1 at 8%	Present Value ($)
Year 1	2,98,500.00	0.9259	276,388.89
Year 2	298,500.00	0.8573	255,915.64
Year 3	298,500.00	0.7938	236,958.92
Year 4	298,500.00	0.7350	219,406.41
Year 5	298,500.00	0.6806	203,154.08
Year 6	298,500.00	0.6302	188,105.63
Year 7	298,500.00	0.5835	174,171.88
Year 8	298,500.00	0.5403	161,270.26
Year 9	298,500.00	0.5002	149,324.32
Year 10	298,500.00	0.4632	138,263.26
Totals	2,985,000.00		2,002,959.30
Amount invested			(2,000,000.00)
Net present value			2,959.30

• Alternatively, present value of cash flow can be found using PVAF, since the cash flows are in the form of an annuity.
  • Present value of annuity factor(8%, 10 years) = 6.71 (from PVAF table)
  • ∴ PV of cash flows = $298,500 × 6.71008 = $2,002,959
  • NPV = $2,002,959 - $2,000,000 = $2,959
• Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over the life of an investment project.
• NPV is used to evaluate investment projects in capital budgeting.
• A project with a positive NPV is accepted. A positive NPV indicates that the project will result in net cash inflows in today's dollars.
• A project with a negative NPV is rejected. A negative NPV indicates that the project will result in net cash outflows in today's dollars.
• The cash flows are discounted at a required rate of return. It may be a weighted average cost of capital, cost of debt, etc.