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This is a question from kaplan revision 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?This is the answer:
PV of contract price should just cover the PV of the project costs to be acceptable.Time Flow DF@10% PV
0 (125,000) 1 (125,000)
0 (4,000) 1 (4,000)
2 4,000 0.826 3,304
–––––––
125,696
–––––––
Therefore, contract price @ time 2 × 0.826 = 125,696
Price = 125,696/0.826 = $152,174 or $152,000 to the nearest $000.I don’t understand why they are again dividing the Total PV by 0.826 to find the contract price
If the contract price was to be received at time 0, then it would have to be at least 125,696 (so as to give an NPV of zero).
However it will not be received until time 2, and so the PV of the amount has to be 125,696.
Therefore if the amount is X x (the 2 year discount factor at 10%) must be equal to 125,696.
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