You are considering an investment in a new sub-industry of interest to your firm. To understand the importance of terminal value assumptions you have decided to calculate NPV under two different sets of assumptions. The project requires an initial outlay of $ 200,000. In addition, after-tax cash flows for years one through six will be $ 25,000 per year. The appropriate discount rate for this project is 12 percent. To deal with the projects terminal value you are considering two potential methods of modifying the end-of-year-six cash flow.
i. Assume the end-of-year seven cash flow is 1 percent larger than the end-of-year-six cash flow. The cash flows will continue to grow in perpetuity at a constant rate of 1 percent thereafter.
ii Assume the project can be liquidated at the end of year six (after receiving the end-of-year-six cash flow) to net an additional after-tax-cash inflow of $ 65,000.
a. Calculate the project NPV assuming i.
b. Calculate the project NPV assuming ii.
c. Interpret your answers to a and b. In your discussion, clarify how the assumptions must coincide with management decisions.
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