Brett Collins is reviewing his company’s investment in a cement plant. The company paid $12,000,000 five years ago to acquire the plant. Now top management is considering an opportunity to sell it. The president wants to know whether the plant has met original expectations before he decides its fate. The company’s discount rate for present value computations is 8 percent. Expected and actual cash flows follow:
Required
Round your computations to the nearest whole dollar.
a. Compute the net present value of the expected cash flows as of the beginning of the investment.
b. Compute the net present value of the actual cash flows as of the beginning of the investment.
c. What do you conclude from this post audit?
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SOLUTION
a.
Cash Inflows
Table Value*
Present Value
Year 1
$2,640,000
x
0.925926
=
$ 2,444,445
Year 2
3,936,000
x
0.857339
=
3,374,486
Year 3
3,648,000
x
0.793832
=
2,895,899
Year 4
3,984,000
x
0.735030
=
2,928,360
Year 5
3,360,000
x
0.680583
=
2,286,759
Cash outflows
Cost of investment
(12,000,000)
Net present value
$ 1,929,949
*Table 1, n = 1 – 5, r = 8%
b.
Cash Flows
Table Value
Present Value
Year 1
$2,160,000
x
0.925926
=
$ 2,000,000
Year 2
2,448,000
x
0.857339
=
2,098,766
Year 3
3,936,000
x
0.793832
=
3,124,523
Year 4
3,120,000
x
0.735030
=
2,293,294
Year 5
2,880,000
x
0.680583
=
1,960,079
Cash outflows
Cost of investment
(12,000,000)
Net present value
$ (523,338)
c.
The postaudit reveals that the original cash flow estimates were inaccurate. Had the decision makers known the real cash flows in advance, they would have rejected the investment opportunity. This result may also cause forecasters of cash flows to be more conservative in their future forecasts.