Calculating NPV for a Project
John owns a nursery school. He estimates that, with an extension, he would be able to sell the business as a going concern for $600,000 in six years time. Without the extension, he would expect to sell it for $500,000 in six years’ time. A local builder has recently approached John with an unexpected offer to buy the nursery now for $850,000.
John needs to decide whether to carry on in business without the extension (Option 1), have the extension built (Option 2), or sell to the developer (Option 3). The following information is available.
1. John has already obtained preliminary planning permission for the extension at a cost of $1,200.
2. John’s building costs are estimated to be $85,000. Of this amount, $45,000 relates to materials and must be paid immediately. The balance of the building costs relates to labour and will be paid on completion of the work. The work would take one year to complete. The nursery would still be open as usual during the year so revenue would be unaffected by the building work.
3. The nursery currently generates net cash inflows of $98,000 per annum. With the extension, these would rise to $135,000 once the work is complete. John pays himself a salary, but this amount has already been deducted before arriving at the $98,000.
4. The nursery’s cost of capital is 10% per annum.
5. Assume that all cash flows occur at the end of each year, unless otherwise stated.
Calculate the net present value (NPV) of each option at the business’ cost of capital. Based on these calculations, conclude as to which option John should choose.
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