Considering the information for the Proposal concerning the building of the new factory, the incremental cash flows are needed for the NPV analysis. The incremental cash flows are sales of $3 million a year which equals an increase in gross margin by $150,000 given a 5% gross margin and initial on investment of $10 million which is the cost of building the new factory. The savage value at the end of the project life will be $14 million. Given a 10% weighted average cost of capital, the following table shows the net present value that is computed for this project.
As shown in the present value table, the NPV of the capital project is $3,680,709 on the negative side which means the project will result in the decrease in the wealth of the company’s stockholders, resulting in violation of the wealth maximization concept. The analysis as per the proposal was done for 10years which is the expected economic life of the new factory. At the end of the economic life of the new factory, the cash flow includes the $14 million expected recovery from selling the factory. Time value of money is the concept that an dollar attain today will be valued more than the same dollar attained at a date in the future and can be computed by the following formula 1(1+r)^t. The PV of each of the cash flows was calculated by multiplying the cash flow with the present value column. If the weighted average cost of capital is 6%, then the net present value is negative $1,078,460 as shown in the table below which is higher than the net present value at 10% of the cost of capital.
It is safe to say that the higher the cost of capital the firm has, the lower the net present value. The capital project manages the planning and make up the non-current portion of a company’s balance sheet which is usually the largest asset portion. The long-term investment project requires relatively large sums to acquire, develop and maintain a capital asset such as land, roads and factory. Capital budgeting decisions is the deciding factor on whether a company can survive long-term or not.