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Hello,
I have the below question which I do not understand. PLEASE can you assist
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 be received at the end of the contract?
The answer is: $152,174
Can somebody please walk me through how you get this answer?
Thank you
For a minimum contract price, the net present value must be equal to zero.
You can calculate the present value of the initial cost, the initial working capital, and the recover of working capital in two years time. This comes to – 125696
Therefore if X is the contract price in two years time, the PV of X discounted for 2 years must be 125696.
So X must equal 125696 / 0.826 = 152174.
The cash flows (ignoring the contract price) are:
time 0 Machine set up costs (125,000
time 0 Working capital (4,000)
time 2 Working capital recovered 4,000You calculate the present value of these by discounting at 10%
I think you will find it useful to watch my free lectures on investment appraisal (and if necessary the relevant F2 lectures, because this is revision of Paper F2).
Our free lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.
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