Net Present Value
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
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
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
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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