Finance
To evaluate the project for T-Mobile, we need to take into account the present-day value of future cash flows. This means that the future cash flows need to be discounted. The case example gives both the future cash flows and the discount rate for T-Mobile, which is the company's cost of capital. The net present value calculation relies on the following equation:
PV of CF = CF1 / (1+r) 1 + CF2 / (1+r) 2 + CF3 / (1+r) 3 + CF4 / (1+r) 4 + CF5 / (1+r)
This is the present value of the future cash flows. Note that as the discount rate is compounding: the longer into the future the cash flow is the more heavily it is discounted. This reflects that time equates to risk, so the further into the future the flow is, the greater risk that the flow change. Thus, the discount rate for future flows must be higher than for flows closer to the present day.
The PV formula provides the present value of the future flows. The net present value calculation then subtracts the present value of the future flows from the known current flows, in this case the $4 million initial investment. The present value of the future flows is as follows:
Year
Cash Flow
350,000
1,700,000
2,000,000
500,000
3,000,000
PV
330,189
1,512,994
1,679,239
396,047
2,241,775
NPV
6,160,243
Discount Rate
0.06
To finish the NPV calculation, we must then subtract from this the current flows:
$6,160,243 - $4,000,000 = $2,160,243
The net present value of this project is $2.16 million. Therefore, the T-Mobile should accept this project. The rule of thumb with respect to using net present value to evaluate whether or not a project should be undertaken is that if the project has a positive net present value, it should be accepted. This is because the discount rate equates to the expected rate of return on the company's existing operations. Thus, any project that is more valuable to the company than its existing operations is one that the company should undertake.
There is a caveat to the assumption that the project should always be accepted if...
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