To evaluate the project, we can use the Net Present Value (NPV) method. NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time, discounted at the company's cost of capital.
The NPV formula is given by:
NPV = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t} - C_0
where:
-CF_t is the net cash flow during the period t ,
- r is the discount rate (cost of capital),
- n is the total number of periods,
- C_0 is the initial investment cost.
Given that:
- Initial investment C_0 = £18,000,
- Cash inflows in year 1 CF_1 = £10,009,
- Cash inflows in year 2 CF_2 = £8,000,
- Cash inflows in year 3 CF_3 = £6,000,
- Cost of capital r = 0.10 (10%),
Substitute these values into the NPV formula:
NPV = \frac{£10,009}{(1 + 0.10)^1} + \frac{£8,000}{(1 + 0.10)^2} + \frac{£6,000}{(1 + 0.10)^3} - £18,000
Calculate the NPV to determine whether the project is a good investment or not.
NPV \approx \frac{£10,009}{1.10} + \frac{£8,000}{(1.10)^2} + \frac{£6,000}{(1.10)^3} - £18,000
NPV \approx £9,099.09 + £6,611.57 + £4,507.89 - £18,000
NPV \approx £2,218.55
Since the NPV is positive (£2,218.55), the project is considered financially viable. A positive NPV suggests that the project is expected to generate more cash inflows than the initial investment, providing a return greater than the cost of capital (10%). Therefore, it may be advisable for the company to invest £18,000 in this project.