Digital Healthcare Co., a mid-size electronic medical device maker, has decided to downsize as a measure to reduce cost in response weak demand. The company is considering implementing one of two plans:

1)Plan A: the first plan involves closing and selling a manufacturing plant in Maple Ridge, which is expected to generate a salvage value of $5 million today (year 0) and save $1.5 million annually in cost and expenses over the next 10 years (years 1 to 10). However, the company will lose $1 million in revenue the first year (year 1), and the loss will increase by 10% per year over the following 9 years (years 2 to 10).

2)Plan B: the second plan involves closing and selling an R&D division in North Van that will generate $8 million today (year 0). Revenue will not be affected for five years but will suffer a reduction of $3 million in years 6-10 due to lack of competitiveness.

The company's cost of capital (i.e., the discount rate it should use) is 12% per year. What is the net present value of each plan? Assume you can ignore taxes. (Note: Your answer should be expressed in units of millions of dollars.)

NPV Plan A = $____ million

NPV Plan B = $____ million

NPV Plan A is 5.231117281 million dollars

 

NPV plan B is 1.86365952 million dollars

 

Decision: Plan A NPV is more. So Plan should be chosen

Step-by-step explanation

Plan A (all amount in millions of dollar)

 

Year 0

salvage value received today .... 5

Present value is same as value as it is received today.

 

Year 1-10

Annual savings in cost..............1.5

cost of capital rate (i) =12%

 

This is constant. so present value of ordinary annuity formula will be used.

 

Present value of ordinary annuity = P*(1-(1/(1+i)^n))/i

=1.5*(1-(1/(1+12%)^10))/12%

=8.475334543

 

Present value of savings in cost = 8.475334543

 

 

Year 1-10

Lost revenue in first year ......-1

this will increase by 10%. So growth rate (g) =10%

number of years (n) =10

 

Present value of growing annuity= (Annuity *(1-((1+g)^n/(1+i)^n))/(i-g)

(-1*(1-((1+10%)^10/(1+12%)^10)))/(12%-10%)

=-8.244217262

 

NPV = sum of all present values

= 5 +8.475334543-8.244217262

=5.231117281

 

NPV Plan A is 5.231117281 million dollars

 

Plan B

Year 0

salvage value received today .... 8

Present value is same as value as it is received today.

 

Year 6-10

Annual reduction in sales ...........-3

number of years (n) =5

 

Value at year 5 for future cash flows = Present value of annuity

Present value of annuity = P*(1-(1/(1+i)^n))/i

=-3*(1-(1/(1+12%)^5))/12%

=-10.81432861

 

this is value at year 5.

Value at year 0 = FV/(1+i)^n

=-10.81432861/(1+12%)^5

=-6.13634048

 

NPV = sum of present value of all cash flows

=8-6.13634048

=1.86365952

 

NPV plan B is 1.86365952 million dollars

 

Decision: Plan A NPV is more. So Plan should be chosen