Scenario: A new product manager presents to you, the chief financial officer, a proposal to expand operations that includes the purchase of a new machine. The product manager is certain that the positive cash flows, which exceed the initial outlay by $20,000 by the end of Year 4, will bring both praise and approval. You explain the company uses a 12% discount rate for cash flows and project-related budgeting. You take the time to present the details of the net present value (NPV) model used to assess product proposals. The data is below.
Project Outflows to Buy Machine
Day 1 Cash Out -$70,000 12% discount rate applied.
End Year 1 Cash Repayment $10,000
End Year 2 Cash Repayment $20,000
End Year 3 Cash Repayment $30,000
End Year 4 Cash Repayment $30,000
To educate the new manager, and as CFO, you take the time to evaluate the following:
Checklist:
Evaluate how the time value of money concept results in a discounted cash flow in Year 4 (an amount less than $30,000).
Assess the investment option using a 12% cost of capital discount rate by applying the NPV model. Provide the NPV at a 12% cost of capital discount rate. Include values in your assessment.
Assess the investment option when a 7% cost of capital discount rate, versus a 12% cost of capital discount rate, is applied. Provide the NPV at a 7% cost of capital discount rate. Include values in your assessment.
