Reference no: EM133059770

Net Present Value Working out the Present Value Determining the Net Present Value of a project involves adding up all the potential cash flows - positive and negative - after they've been discounted to today. (The cash you receive (inflows) are positive numbers; the cash you spend (outflows) are negative numbers.)

entails the same calculations, but it includes the initial cost of the project.

For example, assume Nike is building a new shoe factory at a cost of $75 million dollars. The plant will produce $25 million in cash every year from the shoes Nike will be able to make and sell, for the next five years. Let's use a 10% discount rate for this project.

NIKE FACTORY NPV

25(1.10)1+25(1.10)2+25(1.10)3+25(1.10)4+25(1.10)5=$94.8?M

The Present Value of the project is $94.8 million.

By paying $75 million for a project that is worth $94.8 million, Nike will generate $19.8 million in additional value. That's the project's Net Present Value. Because of the $19.8 million increase in value, Nike should go ahead and build the factory. This is one of the key decision-making rules in finance - companies should undertake projects with positive Net Present Values.

Sunk Costs and NPV

The next year, Nike takes another look at production. Unfortunately, sales have not been good. Instead of making $25 million in the first year, Nike has only made $10 million, and expects this trend to continue for the next four years.

NIKE FACTORY NPV (AFTER ONE YEAR)

10(1.10)1+10(1.10)2+10(1.10)3+10(1.10)4=$31.7?M

The Present Value of the future cash flows of the Nike factory are $31.7 million.

Say a rival company approaches Nike and offers to buy the factory for $40 million. Should Nike take the deal? Remember that Nike spent $75 million to build the factory.