Net Present Value

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Currently the diversification of the business operations has implied that competition in the business sector have moved to the next level. Businesses tend to specialize in the production of a given product in order to safeguard their competitive nature. Consumer Products Inc. aims at achieving the competitive nature of its operation and ensuring that the company dictates the market operations. This has been done by increasing its business functions by incorporating its major three brands (Shades of Youth, Super Clean and Super white) to the neighboring economies; Dallas, Chicago, New York, Charlotte, and Miami. In determination of the inherency of the management decision to undertake the expansion strategy, the Net Present Value of its cash flows is analyzed.

Year                Cash flow       PVIF (6%)                  PVs    

0                      (50)                                                    (50)

1                      8.76                 0.9434                        8.264

2                      13.10               0.8900                        11.659

3                      18.06               0.8369                        15.114

4                      23.02               0.7921                        18.230

5                      26.12               0.7473                        19.520

                                                NPV                           22.787

The project to be initiated has a positive NPV of 22.787 implying that the business can undertake the investment and realize the economic benefit. The management should consider investing in the project.  In calculation of the certainty equivalent cash flow and NPV, the forecasts of the subsequent cash flow of the project is reduced by use of risk adjustment factor.   The Net Present Value for the project's cash flow will be calculated as;

Net present value = (The risk adjusted factor X the forecasts of net cash flow) / (1 + Risk free rate)

Risk adjustment factor = certain net cash flow / Risky net cash flow

                        = 72.787/89.06

                        = 0.82

Year    forecast cash flow     Risk adjusted factor     certain cash flow PVIF (2.25%)       PVs

0           (50)                                                                                                                          (50)

1          8.76                           0.82                            7.1832                         0.9780             7.0252

2          13.10                           0.82                            10.742                         0.7115             7.6429

3          18.06                           0.82                            41.809                         0.6958            10.3042

4          23.02                           0.82                            18.876                         0.6805           12.8454

5          26.12                           0.82                            21.418                         0.6655            14.2539

                                                                                  NPV                                                  2.0716

The NPV denoted by the certainty equivalent shows a positive value implying that the project is desirable and the management can invest on it. This is after factoring in the risk adjustment factor in order to come up with certain cash flows that can be of consequential importance in coming up with an informed decision on the project to invest on.  

This approach tends to recognize the risk inherent when venturing into a given investment option. Despite its explicit nature of cash flow discounting, certainty equivalent of NPV and cash flows is inconsistent when reducing the cash flows of different forms of investments. Therefore, the management need not have to rely on this option of cash flow discounted in making investment decisions. It should also analyze the environment that the business operation is venturing into.

The management should understand the economic changes that the society is facing. Do they have sufficient resources to curb the dynamic economic environment? What are the staff members doing to ensure that they are acquainted with the changes experienced in the economic? The management is assumed to be well conversant with the changing economy and the political instability that may affect the overall tranquility of the business operations (Eugene F. Brigham P. R., 2009). The expansion strategy should be adopted given that it produces a positive NPV when all other factors, both economic and political, are kept constant.

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