The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000-gallon capacity plant costs $500,000 to build and has an indefinite life, with no salvage value. The cost of capital is 20 percent (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.50. Assuming that the competition will never catch up and the market demand is sufficiently high, what is the net present value of building a new plant with new technology?

Question

Quizplus · Accepted Answer

1. First, we need to calculate the annual savings from the new process:

Savings per gallon = $2 – $1.50 = $0.50

Annual savings = Savings per gallon x Annual output = $0.50 x 100,000 gallons = $50,000

2. Next, we need to calculate the net present value (NPV) of the new plant:

NPV = -Initial investment + Present value of future cash flows

NPV = -$500,000 + ($50,000 / 0.20)

NPV = -$500,000 + $250,000

NPV = $-250,000

Because the initial investment is greater than the present value of future cash flows, the NPV is negative. Therefore, building a new plant with the new technology is not a good investment and has a negative net present value.

The Manufacture of Herbal Health Tonic Is a Competitive Industry