A firm can spend 1000000 today on a project that will genera

A firm can spend $1,000,000 today on a project that will generate $2,000,000 of revenue exactly 10 years from now. Should the firm do this project? Evaluate using the net present value (NPV) criterion and a discount rate of 7%.

Solution

Initial outlay = $1,000,000

Expected return = $2,000,000

Time period (n) = 10 years

Discount rate (r) = 7% or 0.07

Calculate present value of expected return -

Present value = Expected return/(1+r)ⁿ = $2,000,000/(1+0.07)¹⁰ = $2,000,000/1.07¹⁰ = $1,015,228.43

The present value of expected return is $1,015,228.43.

Calculate Net Present Value -

Net Present Value = Present value of expected return - Initial Outlay

                           = $1,015,228.43 - $1,000,000

                           = $15,228.43

The Net Present Value is $15,228.43.

Positive net present value indicates that project is profitable and vice-versa.

As Net Present value is positive, the firm should do this project.