Dr. Yuan opens a lab. The lab has an initial cost of $100,000. Expected net cash flow is $24,000 in the first year, growing by 15% per year. Net cash flow is revenue less expenses. Assume the lab has a 6 yr life and there is no scrap value for the lab. Later that same year, Dr. Bhat opens a similar lab in the strip mall less than two miles away from Dr. Yuan. Dr. Yuan estimates her net cash flow in the first year will be considerably less than her initial estimate. She estimates it will be $16,000. All else equal, what happens to the NPV of Dr. Yuan’s lab?
a) The NPV decreases, but is still positive. Dr. Yuan can still expect a positive return on her investment.
b) The IRR decreases, but is still positive. Dr. Yuan can still expect a positive return on her investment.
c) The IRR decreases, and becomes negative. Dr. Yuan should expect a loss on this investment.
d) The IRR and the NPV decrease. Dr. Yuan can still expect a positive return on her investment.
Assume instead that Dr. Yuan forms a partnership with Dr. Bhat. They agree to share the $100,000 cost equally and to share the cash flow equally. Because of efficiency gains from longer operating hours, they expect the net cash flow to be $32,000 per year. Assume they expect net cash flow to grow at 15% per year. What is the consequence of the partnership to Dr. Yuan? Please compare the results to the original scenario described in question 13 (Dr. Yan opening the only lab in the area).
a) The NPV decreases, but is still positive. Dr. Yuan can still expect a positive return on her investment.
b) The NPV decreases, and becomes negative. Dr. Yuan should expect a loss on this investment.
c) The IRR decreases, but is still positive. Dr. Yuan can still expect a positive return on her investment.
d) The IRR and the NPV increase. Dr. Yuan can still expect a positive return on her investment

d

d

Explanation:

Net present value is the present value of after-tax cash flows from an investment less the amount invested.  

Only projects with a positive NPV should be accepted. A project with a negative NPV should not be chosen because it isn't profitable.  

When choosing between positive NPV projects, choose the project with the highest NPV first because it is the most profitable.

Internal rate of return is the discount rate that equates the after-tax cash flows from an investment to the amount invested

NPV and IRR can be calculated with a financial calculator

Dr Yaun's inital strip mall

Cash flow in year 0 =  $-100,000

Cash flow in year 1 =  $24,000

Cash flow in year 2 =  $24,000 x 1.15

Cash flow in year 3 =  $24,000 x 1.15^2

Cash flow in year 4 =  $24,000 x 1.15^3

Cash flow in year 5 =  $24,000 x 1.15^4

Cash flow in year 6 =  $24,000 x 1.15^5

I = 10 %

NPV = $46,718,00

IRR = 22.85%

Similar Strip Mall

Cash flow in year 0 =  $-100,000

Cash flow in year 1 = $16,000

Cash flow in year 2 = $16,000 x 1.15

Cash flow in year 3 =  $16,000 x 1.15^2

Cash flow in year 4 =  $16,000 x 1.15^3

Cash flow in year 5 =  $16,000 x 1.15^4

Cash flow in year 6 =  $16,000 x 1.15^5

I = 10 %

NPV = $2188

IRR = 9.33%

It can be seen that both the IRR and NPV decreases but still remain positive. So, Dr. Yuan can still expect a positive return on her investment.

The partnership

Cash flow in year 0 =  $100,000/ 2 =$-50,000

Cash flow in year 1 = $32,000 / 2

Cash flow in year 2 = ($32,000 x 1.15)/2

Cash flow in year 3 = ($32,000 x 1.15^2)/2

Cash flow in year 4 = ($32,000 x 1.15^3)/2

Cash flow in year 5 = ($32,000 x 1.15^4)/2

Cash flow in year 6 = ($32,000 x 1.15^5)/2

I = 10 %

NPV = $47,812

IRR = 34.49%

It can be seen that the NPV and IRR are both higher when compared with the first scenario

To find the NPV using a financial calculator:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. after inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.  

3. Press compute  

To find the IRR using a financial calculator:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. After inputting all the cash flows, press the IRR button and then press the compute button

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