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Hi John,
In this question, I would want to clarify 3 questions below. Let me abbreviate the option to continue US production as 1st option, and the other choice to invest overseas as 2nd option.
1. Why do we have to include the opportunity cost of 1st option to continue production in US into our NPV analysis? Opportunity cost is not cash so we should not include in analysis right?
2. My approach to this opportunity cost was to calculate the NPV of 1st option in a separate working. Then, my APV calculation for the 2nd option need to result in a APV amount that is higher than the NPV of the other option to ensure that the 2nd option is better. Is this a correct approach?
3. If my approach in question 2 is correct, what is the discount rate I should use for calculating the NPV of the 1st option? The WACC 7% that the question stated is for the case we undertake the overseas investment only. Do we have to calculate a separate WACC for the NPV calculation of this 1st option?
Thank you.
1. Opportunity costs are always included in NPV analysis – they are lost cash from elsewhere in the business.
2. You could do this, but given that the question specifically suggests the approach then you should really do it the way that the examiners answer has done it.
3. You would use the same discount rate for both.
I am guessing from what you have asked, that you were exempt from Paper F9 and it would help you to watch the Paper PM (F9) lectures on investment appraisal.
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