I'm in great need of help with a finance problem.
You are a small business owner and you have the opportunity to expand your facility, which will increase your production capacity over the next 5 years. The expansion will cost $60,000 and additional equipment will cost another $20,000.
Required:
Additional profits after tax will amount to $18,000 per year. Your cost of capital is 8%. Should you go ahead with the expansion? Hint: Use NPV.
I know the total cash outflows will be $80,000. But I am confused on the rest. Please help me. Thanks in advance.
NPV = -initial investment(outflows) + (cash inflow/(1 + rate)^Year)) and so on for period of time calculating for. In this case, it would be -$80,000 + ($18,000/(1+.08)) + ($18,000/(1+.08)^2) + ($18,000/(1+.08)^3) + ($18,000/(1+.08)^4) + ($18,000/(1+.08)^5). Calculate this out and if the NPV is positive, the project should go ahead. If it is negative, it should not. These calculations can also be done in Excel using NPV function.
To determine whether you should go ahead with the expansion, you need to calculate the Net Present Value (NPV) of the project. The NPV takes into account the time value of money and helps you compare the present value of cash inflows and outflows over a specific time period.
Here's how you can calculate the NPV:
1. Determine the cash inflows: In this case, the additional profits after tax will amount to $18,000 per year over the next 5 years.
2. Determine the cash outflows: The expansion will cost $60,000 and the additional equipment will cost $20,000. So the total cash outflows will be $60,000 + $20,000 = $80,000.
3. Determine the discount rate: The discount rate is your cost of capital, which is given as 8%.
4. Calculate the present value of cash inflows: To do this, you need to discount each year's cash inflow by the discount rate. The formula to calculate the present value (PV) is PV = CF / (1 + r)^n, where CF is the cash flow in a particular year, r is the discount rate, and n is the year.
In this case, the present value of the cash inflows for each year would be:
Year 1: $18,000 / (1 + 0.08)^1
Year 2: $18,000 / (1 + 0.08)^2
Year 3: $18,000 / (1 + 0.08)^3
Year 4: $18,000 / (1 + 0.08)^4
Year 5: $18,000 / (1 + 0.08)^5
5. Calculate the NPV: The NPV is the sum of the present values of cash inflows minus the cash outflows. So, the NPV formula is: NPV = PV1 + PV2 + PV3 + PV4 + PV5 - Cash outflows.
By calculating the NPV and comparing it to zero, you can make a decision:
If NPV > 0, then the project is expected to generate more return than the discount rate, and you should go ahead with the expansion.
If NPV < 0, then the project is not expected to generate enough return to cover the cost of capital, and you should not go ahead with the expansion.
By plugging in the values and calculating the NPV, you will be able to make an informed decision.