The Horizon Company will invest $67,000 in a temporary project that will generate the following cash inflows for the next three years. Calculate your final answer using the formula or financial calculator methods.
Year Cash Flow
1 $21,000
2 34,000
3 36,000
The firm will also be required to spend $18,000 to close down the project at the end of the three years.
a. Compute the net present value if the cost of capital is 9 percent.
Note: Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.
Net present value
b. Should the investment be undertaken?
No
Yes
Answer (2)
To determine whether Horizon Company should undertake the investment, we need to calculate the Net Present Value (NPV) of the project. NPV is a method used in capital budgeting to evaluate the profitability of an investment. It sums the present values of all cash inflows and outflows associated with the investment, discounted using the firm's cost of capital.
Here's how to calculate the NPV for Horizon Company's project step-by-step:
List the cash flows and closing cost :
Initial Investment at Year 0: − 67 , 000
Year 1 Cash Flow: 21 , 000
Year 2 Cash Flow: 34 , 000
Year 3 Cash Flow: 36 , 000
End of Project Closing Cost at Year 3: − 18 , 000
Determine the discount rate : The cost of capital is given as 9% or 0.09 in decimal form.
Calculate the present value of each cash flow :
Year 0 (Initial Investment) : Already in present value, so it is − 67 , 000 .
Year 1 Cash Flow : P V = ( 1 + 0.09 ) 1 21 , 000 = 1.09 21 , 000 ≈ 19 , 266.06
Year 2 Cash Flow : P V = ( 1 + 0.09 ) 2 34 , 000 = 1.1881 34 , 000 ≈ 28 , 619.28
Year 3 Cash Flow : P V = ( 1 + 0.09 ) 3 36 , 000 = 1.295029 36 , 000 ≈ 27 , 793.09
Year 3 Closing Cost : P V = ( 1 + 0.09 ) 3 − 18 , 000 = 1.295029 − 18 , 000 ≈ − 13 , 896.54
Sum all the present values : NP V = − 67 , 000 + 19 , 266.06 + 28 , 619.28 + 27 , 793.09 − 13 , 896.54 ≈ − 5 , 218.11
Decision based on NPV :
If the NPV is greater than zero, it indicates that the investment should earn a return above the cost of capital, and hence the investment should be undertaken.
If the NPV is less than zero, the project will not cover the cost of capital and thus should not be undertaken.
For Horizon Company's project, the NPV is − 5 , 218.11 , which is less than zero. Therefore, the investment should not be undertaken .
Hence, the answer to part (b) is: No .
The Net Present Value (NPV) for the Horizon Company's project is calculated to be approximately -5,218.11, indicating that the project would not cover the cost of capital. Therefore, the investment should not be undertaken. The answer to part (b) is: No.
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