It is sometimes stated that “the net present value approach assumes reinvestment of the intermediate cash flows at the required return.” Is this claim correct? To answer, suppose you calculate the NPV of a project in the usual way. Next, suppose you do the following:
- Calculate the future value (as of the end of the project) of all the cash flows other than the initial outlay assuming they are reinvested at the required return, producing a single future value figure for the project.
- Calculate the NPV of the project using the single future value calculated in the previous step and the initial outlay. It is easy to verify that you will get the same NPV as in your original calculation only if you use the required return as the reinvestment rate in the previous step.
You are considering a new product launch. The project will cost $1,950,000, have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 210 units per year; price per unit will be $17,500, variable cost per unit will be $10,600, and fixed costs will be $560,000 per year. The required return on the project is 12 percent, and the relevant tax rate is 21 percent.
- Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios?
- Evaluate the sensitivity of your base-case NPV to changes in fixed costs.
- What is the cash break-even level of output for this project (ignoring taxes)?
- What is the accounting break-even level of output for this project? What is the degree of operating leverage at the accounting break-even point? How do you interpret this number?