A project requires an additional commitment of $100,000 in net working capital in each of years 1 to 4.These extra investments can be recovered in year 5 when the project comes to an end.What is the effect on NPV?
A) NPV is reduced by $100,000.
B) NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for 4 years.
C) NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for each of years 1 to 4 minus the discounted value of the $400,000 that is recovered in year 5.
D) No opportunity cost is involved.

Question

Quizplus · Accepted Answer

The additional investment in net working capital in each of years 1 to 4 represents an outflow of cash and thus reduces the project's NPV. We need to calculate the present value of these outflows using the firm's cost of capital for each of the years 1 to 4. However, we also need to consider that these investments will be recovered in year 5, so we need to subtract the present value of the $400,000 that will be recovered. Therefore, NPV is reduced by the present value of $100,000 discounted at the firm's cost of capital for each of years 1 to 4 minus the discounted value of the $400,000 that is recovered in year 5.

A Project Requires an Additional Commitment of $100,000 in Net