Suppose a small firms begins its operation by buying a shop that costs 90,000. It plans to write off linearly this single up-front investment over three years. In each and every one of the following years the firm expects to earn 60,000 in revenue per year and for its workforce and merchandise it will face costs of 20,000 per year. The corporate tax rate is 30% and the market interest rate is expected to be 2% forever. The firm has no plans to take on debt but plans to remain a pure equity firm forever. (a) What is the net present value (NPV) of this new firm?

Model Answer

In the first year the firms free cash flow is FCF0 = -53,000 in the second and third year it is FCF1 = FCF2 = 37, 000. From then onwards it will be FCFt = 28,000, for t = 3, 4, ... Therefore, the NPV is

NPV =1,364,500

Please explain how the NPV is 1,364,500. Explain how t=0 is -53,000