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 have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in five years 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

First, we need to calculate the present value of the operating costs of the new plant over five years using the given discount rate of 20%. 
PV of operating costs = $1 x 100,000 x (1 - 1/1.20^5) / 0.20 = $232,827.10

Next, we need to calculate the net present value of building the new plant.
NPV = - Initial investment + PV of future cash flows 
Initial Investment = $500,000 
Future cash flows = savings in operating costs per gallon x number of gallons x number of years 
= ($2 - $1) x 100,000 x 5 
= $500,000

PV of future cash flows = $500,000 x 1 / 1.20^5 
= $217,938.37

NPV = -$500,000 + $217,938.37 + $232,827.10 
= $-49,234.53

Since the NPV is negative, it would not be financially viable to build the new plant with the new technology, as it would result in a loss for the company. Therefore, the best choice is C.

The Manufacture of Herbal Health Tonic Is a Competitive Industry