Problem-2 (Net present value analysis – handling working capital)

By: Rashid Javed | Updated on: September 11th, 2022

The Universal Trading Company has obtained a license to introduce a new product for 6 years. The product would be purchased from manufacturing company for $10 per unit and sold to customers for $20 per unit. The estimated annual cash expenses to sell the new product would be $18,000. Other important information associated with the new product is given below:

  • Cost of equipment needed: $30,000
  • Working capital needed: $40,000
  • Repairs and maintenance of equipment after 5 years: $2,500
  • Residual value of equipment after 6 years: $5,000

The working capital would be released at the end of 6-year period. The expected annual sales are 5,000 units of product. The discount rate of the company is 16%.

Required:

  1. Compute net present value (NPV) of the new product. (Ignore income tax).
  2. Would you recommend the addition of new product?

Solution:

(1) Net present value (NPV) of new product:

problem-2-cbt-img1

*Value from “present value of an annuity of $1 in arrears table“.
**Value from “present value of $1 table”.

(2) Conclusion:

Yes, the addition of new product is recommended to Universal Trading Company because its net present value (NPV) is positive.

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