Net Present Value (NPV) -

Net Present Value (NPV) - Cash Flow Calculations With respect to the issue of Clink's potential investment in machinery to produce cligs, Clink should pursue this project. The net present value of the cash flows relating to this project has been calculated to be £200,282. Because the project has a positive net present value, it should be pursued by Clink. The NPV was calculated on the basis of the expected cash flows deriving from the project. Not included in the calculation were the tax effects of depreciation.

Also not included was the allocation of fixed costs. Those costs exist regardless of whether or not Clink pursues cligs, thus they should not be considered when calculating the value of the clig project. Several other factors, however, should be taken into consideration. The first is the tax effects associated with the project. Earnings from the project will be subject to income tax; therefore the true net present value should be calculated on a net basis. The current calculation is gross.

The depreciation on the machinery, however, will provide a tax shield for the project. Again, this should be taken into consideration when deciding whether or not to pursue the project. There are other considerations as well. Clink should take into account the opportunity cost of the project. There may be other projects that offer a higher net present value, or a higher rate of return.

As such, Clink will want to weight those opportunities against this one, in terms of which opportunity represents the most effective use of our scarce resources. Another consideration is with respect to our corporate strategy. We need to ensure that the production of cligs is consistent with our strategy and our vision. If it is not, it could prove a distraction that detracts from other operations in ways we have not intended. The final consideration is the sensitivity of these calculations.

The positive net present value is based on a set of assumptions. A sensitivity analysis should be conducted with respect to analyzing the robustness of our assumptions. In particular, Clink management should be aware of the potential NPV under a worst-case scenario. 2. If Clink could lease the machinery rather than purchase it, the most they should pay for the lease is around £290,000 per annum. To derive this figure, we remove from the previous calculation the initial cost of the machinery and we must also remove the resale value.

Then we calculate, using the Solver function or by trial and error, the amount which gives the project a positive net present value. At £290,000, the NPV is £4428, so that figure is a reasonable approximation of the maximum amount Clink should pay to lease the machinery. However, given that the opportunity cost (buying) has an NPV of £200,282, the lease cost should yield a higher NPV than that in order to be a cost-effective option.

Therefore, Clink should only utilize the lease option is the lease is valued at less than £230,000 per year. Some of the factors that might influence this decision would be the estimated life span of the machinery and the estimated resale value. The longer the estimated life span of the machinery and the greater the estimated resale value, the less likely the lease is to be a viable option. However, there is always a price at which the lease could be more effective.

However, Clink would want to consider the taxation effects of the two options before coming to a decision. Another consideration should be the robustness of the sales assumptions. The lease creates an obligation and that leverage increases the riskiness of the venture. This could affect the discount rate, but if we assume that we will leave the discount rate the same, we must understand that Clink will need to earn enough in each year of the project to cover that obligation. 3.

It could potentially be advisable to lower the price after year 3 in order to spur sales. The lease creates a fixed obligation and Clink needs to make enough money to cover that obligation. The present value of year 4 cash flows is just over £20,000, which does not give Clink must breathing room. In year 5, the clig product is a money-loser under the lease scenario. It must be said, however, that lowering the price to boost sales will not necessarily yield the desired results.

Sales do not alone cover costs, contribution does. Contribution equals sales multiplied by sales price, less variable costs. Clink will need to examine the demand curve to see.