5. Valuation and Selection of Projects

The management of a company considers the execution of a project. The investment needed has an economic lifetime of five years. For the third year of the project the above information has been gathered with regard to the expected influence of this project on the company’s financial statements. A tax rate on profits of 20% should be taken into account. What is the expected cash flow of this project for its third year?

What does the cost of capital of a project mean?

What can be said about the internal rate of return (IRR) of a project when the net present value
is negative?

Suppose it is the autumn of 2020. The management of a manufacturing company considers the use of a machine on January 1, 2021 for certain processes that have so far been executed by stand-by workers. The machine is expected to lead to savings on wages of € 140,000 per year during the term of the project. In addition, for the level of the net working capital needed a one-time reduction of € 50,000 is expected at the start of the project. The purchase price of the machine is € 600,000. This amount will be paid on January 1, 2021. The economic lifetime of the machine is five years. The estimated residual value of the machine (the amount against which the machine can be sold after five years) is € 100,000. In 2020, management commissioned a specialist agency to test the proper functioning of the machine. This investigation cost € 40,000. This amount was paid in August 2020. The investigation made clear that the expected cost savings on wages could be realized with certainty. The cost of capital of the project is set at 5%. For the assessment of the project, a tax rate on profits of 20% should be taken into account. At the end of 2025 there will be a change in net working capital. This change leads to…..

See the project described at question 4. The cash flows of this project at the end of the year 2021, 2022, 2023, and 2024 are equal. The amount of this cash flow is……..

See the project described at question 4. The cash flow at the end of the year 2025 is ……..

See the project described at question 4. The net present value of this project on January 1 of 2021 is ……..

See the project described at question 4. What will happen with the net present value of the project if both the purchase price and the residual value of the machine are € 50,000 higher?