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A company is considering investing in a manufacturing project that would have a three-year life span. The investment would involve an immediate cash outflow of $50,000. In each of the three years, 4,000 units would be produced and sold. The contribution per unit, based on current prices, is $5. The company has an annual cost of capital of 8%.
Year Discount factor
8%
0 1.000
1 0.926
2 0.857
3 0.794Calculate the net present value of the project $_____
Answer is 1540.
My question is that we are already given contribution based on current prices. So why there is need of applying discount factor to reach present values?Question 2:
Which of the following is a disadvantage of the payback method of investment appraisal?A) It tends to maximise financial and business risk.
B) It is a fairly complex technique and not easy to understand.
C) It cannot be used when there are limited funds available.
D) It doesn’t account for the cost of capital in making investment decisions.The answer is d. Please explain Sir Ken Garrett.
The company expects to sell 4000 units per year for three years making a contribution of $5 per unit. However, the amounts will not be received until times 1,2 and 3 do these flows need to be discounted.
The term ‘current price’ really relates to inflation as prices will go up each year and if there were inflation you could work out how much cash would be received each year. However, those amounts still need to be discounted as they are more remote. In this example there seems to be no inflation.
Payback is just a result of the pattern of cash flows and it makes no use whatsoever of the company’s cost of capital. A company with a high cost of capital would need better returns than one with a low cost of capital because it costs more to service the capital. However, the payback period has no mechanism for this to be taken into account.
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