Exercise-22: Net present value (NPV) computation with working capital

Learning objective:
This problem illustrates the net present value (NPV) computation when working capital is involved in a proposal.

Universal Trading Company has obtained a license to introduce a new product for 6 years. The product would be purchased from the manufacturing company for $10 per unit and sold to customers for $20. 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. Expected annual sales are 5,000 units of product. The company’s discount rate 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:

*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.