Question

You are considering opening a new plant. The plant will cost $101.8 million up front and will take one year to build. After that it is expected to produce profits of $29.7 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

Answer 1

NPV = Present value of cash inflows – Present Value of Cash outflows

= 29.7 million/0.077 - $101.8 million

= $283.91 million

Since, NPV is positive, the project should be accepted.

IRR is the rate at which NPV = 0

Let it be x%

0 = 29.7 million/x – 101.8 million

X = 29.17%

Maximum deviation allowed in cost of capital to leave the decision unchanged = 29.17 – 7.7

= 21.47%