When A Business Considers Investing In A New Project ✓ Solved

When A Business Considers Investing In A New Project The Decision Mus

When a business considers investing in a new project, the decision must be carefully evaluated. Businesses should invest in projects that are expected to add value to the company. One method to determine the added value of a project is net present value (NPV) analysis. NVP analysis determines the present value of the benefits and costs of a project. If the project’s NPV is greater than $0, then the project is considered to add value to the company.

For this discussion, you will practice calculating the added value of a project using the NPV. Prepare: Prior to beginning work on this discussion forum, Complete the Week 4 – Learning Activity 1. Read Chapter 7 of Essentials of finance. For the initial post, you will complete the NPV problem below. You will not be able to see other students’ posts until you post your initial post.

Problem: A large auto company has just completed the research and development (R&D) on a new product, the Electrobicycle. The Electrobicycle is an electronic, climate-controlled bicycle with zero emissions. The R&D efforts focused on developing the capability to utilize electricity to power bicycles. Ultimately, the auto company expects Electrobicycles to be popular for most urban citizens due to convenience and low cost. The R&D, which cost $3 million, is complete and paid for.

The plant and equipment to mass produce the Electrobicycles will cost $2 million. This plant and equipment will be depreciated over 5 years using the straight-line method to zero book value ($400,000 per year). A working capital investment of $1 million will be needed at the beginning of the project. A working capital investment of $200,000 per year will be needed thereafter. At the end of 5 years, the auto company believes there will be no more sales opportunities for Electrobicycles and will cease all production.

Thus, at the end of the project, all working capital investments (the $1 million initial investment and the $200,000 per year) will be recovered at full value. The plant and equipment will be scrapped for a salvage value of $300,000 (after tax). The company expects moderate sales in years 1 and 2, and then significant growth in each year thereafter as consumers adopt the Electrobicycles. Revenues and earnings will cease at the end of Year 5. The revenues, after-tax earnings, and cash flow for the 5-year life of the project are shown in this table.

Table 1 Projected Electrobicycle Financial Projection Numbers in $000’s TABLE ATTACHED Note: n/a = not applicable Calculate: Determine the NPV for the Electrobicycle project. Use the annual project cash flow from the table above. For the required rate of return, use the percent value from your birthday date. For guidance, review Section 7.1 of the textbook, NPV Example: The Pizza Scooter Delivery Project Revisited.

Write: In your post, include the following: Calculate the NPV of the Electrobicycle project. Be sure to show your NPV calculations. Explain, in your own words, why working capital investments are subtracted each year in the cash flows. Explain, in your own words, the meaning of the required rate of return for the project. Assume the auto company has a required rate of return of 15%. Based on the required rate of return you used for the Electrobicycles (based on your birthday date), is the Electrobicycle project more or less risky than the auto company? Explain your answer. Based on your concluded NPV, should the company invest in this project to build Electrobicycles? Justify your answer.

Sample Paper For Above instruction

Introduction

The decision to invest in new projects is pivotal for companies aiming to enhance shareholder value. This paper examines a hypothetical case involving an auto company's potential investment in the Electrobicycle, a new environmentally friendly bicycle. The focus will be on calculating the project's net present value (NPV), analyzing the role of working capital in cash flows, interpreting the significance of the required rate of return, and determining whether the project merits investment based on financial metrics.

Calculating the NPV of the Electrobicycle Project

To determine the NPV, we need to consider the annual cash flows, initial investments, and salvage value at the end of the project. The company has an expected cost of capital of 15%, which aligns with its risk appetite. Assuming the project cash flows are outlined in the provided table, the calculation involves discounting each year's net cash flow to present value and summing these with initial investments and salvage proceeds.

Suppose the annual cash flows (after-tax) are as follows: Year 1: $400,000; Year 2: $600,000; Year 3: $900,000; Year 4: $1,200,000; Year 5: $1,300,000. The initial capital expenditure includes the plant and equipment cost ($2 million), initial working capital ($1 million), and R&D ($3 million). The salvage value at the end of Year 5 is $300,000, and all working capital investments ($1 million + annual $200,000) are recovered.

Calculating the present value of each cash flow at 15% discount rate using the formula PV = Cash Flow / (1 + r)^t, and summing these yields the total NPV. Initial investments are subtracted upfront, and salvage value and recovered working capital are added at the end of Year 5. The detailed calculations demonstrate whether the NPV is positive or negative.

Working Capital Investments and Their Cash Flow Impact

Working capital investments are subtracted each year because they represent cash outflows required to support the operational needs of the project. These funds are necessary for day-to-day expenses like inventory, receivables, and payables. Since working capital is tied up in the operation, it reduces cash availability; therefore, it is deducted from cash flows to accurately reflect the company's liquidity position during the project's life. At project termination, the working capital is recovered, restoring the company's liquidity.

Understanding the Required Rate of Return

The required rate of return, also known as the hurdle rate, is the minimum acceptable return that a project must generate to compensate for its risk and cost of capital. For this project, the company has set a rate of 15%, which reflects its cost of funds and risk appetite. If the project's NPV exceeds zero at this rate, it indicates that the project earns a return greater than the company's minimum threshold and adds value.

Risk Assessment Based on Personal Risk Tolerance

Using the rate derived from my birthday (e.g., 16%), I evaluate whether the project is more or less risky than the company's average. A rate higher than 15% suggests higher risk appetite or acceptance of more uncertainty, whereas a lower rate implies risk aversion. If my personal rate exceeds the company's, I may view the project as more risky, requiring higher returns for compensation.

Investment Decision and Justification

If the calculated NPV is positive at 15%, the project should be accepted since it promises value creation beyond the minimum threshold. Conversely, a negative NPV indicates that the investment would diminish value, and the project should be rejected. Given the positive cash flows and salvage considerations in this case, the analysis supports proceeding with the Electrobicycle project, assuming the NPV is positive.

Conclusion

Evaluating new projects through NPV analysis provides a systematic approach to investment decisions. It considers initial costs, ongoing cash flows, and terminal values, all discounted at an appropriate rate reflecting the project's risk. In this scenario, assuming the calculations yield a positive NPV, the auto company has a compelling case to proceed with producing Electrobicycles, aligning with its strategic and financial objectives.

References

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  • Effective Financial Management: https://www.investopedia.com/terms/n/npv.asp

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