Elaine Smith of General Pacific Company is analyzing a 5-year expansion project to increase manufacturing capacity. The project requires an investment in net working capital of $500,000 that will be recovered at the end of the project and has a cost of capital of 10%. In her analysis, Smith assumes that the two cash flows net out to zero over the life of the project, so she does not include a cash flow for net working capital at the beginning or the end of the project. Assuming she correctly analyzes all the other components of the project, Smith has likely: A. overestimated the project’s cash flow by approximately $310,000. B. underestimated the project’s net present value by approximately $310,000. C. overestimated the project’s net present value by approximately $190,000. By ignoring the initial $500,000 cash outflow, she has overestimated project NPV by $500,000. By ignoring the terminal cash inflow of $500,000, she has underestimated project NPV by (500000/(1.155)=310000 The net effect is to overestimate NPV by $500,000 – $310,000 = $190,000.
My question is why do we discount the 500000, as far as I understand, it states that the investor will recover the amount after five years, shouldn’t we multiply thet 500000 by (1.155) to get it value after five years.
I think you are not understanding the logic. The project requires to invest 500k today as working capital. Working capital is said to be recovered at the end of the project (5yr), so if Smith is not considering this investment into the assessment, she is overestimating NPV.