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Hello Sir,
Q 86 on Kaplan 2022-2023 Exam kit
A company is considering investing in a two?year project. Machine set?up costs will be $125,000, payable immediately. Working capital of $4,000 is required at the beginning of the contract and will be released at the end.
Given a cost of capital of 10%, what is the minimum acceptable contract price (to the nearest thousand dollar) to be received at the end of the contract?
$In the above question it is asking the minimum contract price
The cash flows was discounted and the NPV was divided by the discount factor to give the minimum price of the contract.
I am not able to understand the logic behand this calculation
can you please clarify the amount of $152,000 as minimum contract price
Why we divide the NPV again to get the contract price ,
Thanks,
Answer
$152,000
PV of contract price should just cover the PV of the project costs to be acceptable.
Time Flow Discount @ 10% pv
0 (125000) 1 (125000)
1 (4000) 1 (4000)
2 4000 0.826 3304
———
-125696
________
Therefore, contract price @ time 2 × 0.826 = 125,696
Price = 125,696/0.826 = $152,174 or $152,000 to the nearest $000.You are calculating the PV of the contract
The minimum acceptable contract price is determined by calculating the net present value (NPV) of the project’s cash flows.
The NPV represents the present value of the project’s inflows and outflows, discounted at the cost of capital rate. In this case, the machine set-up costs of $125,000 and the working capital of $4,000 are considered outflows at time 0.
The working capital is released at the end of the contract, resulting in a cash inflow time 2.PV (1To calculate the minimum acceptable contract price, the NPV is divided by the discount factor. The discount factor is calculated using the cost of capital rate and the time period of the project. In this case, the project is a two-year project, so the discount factor is calculated as 1 / (1 + 0.10)^2 = 0.826
(125)+(4)+ [ 4* 0. 826] = (125.96)
This is the contract at time 2But we need a PV of it so we take the (125.96) / 0.826 = 152.174 or 152k
Hi Tutor,
My confusion is if we calculate the NPV of the contract
(125)+(4)+(4* 0.826) = (125.96)
This is the contract at time 2you said it is the contract at time two ,but here we have the present value the cash flow of year two is already discounted to year 0
So shouldn’t it be the contract value at 0 because we already discounted to time 0
when we multiply 4* .826Can you please clarify more.
Thanks,
It’s what is the minimum acceptable contract price (to the nearest thousand dollar) to be received at the end of the contract?
So PV of an end of the contract
(125)+(4)+ [ 4* 0. 826] = (125.96) NPV of projects cash flows
But we need value today so we take the (125.96) / 0.826 = 152.174 or 152k
PV – calculate the minimum acceptable contract price, the NPV is divided by the discount factor
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