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This is not a reason to continue operating a plant.
In light of the information given in the problem, calculating the breakeven point is not the correct way to approach this problem. To answer this question, first calculate the immediate (Year 0) cost to shut down the plant, and then compare that with the net present value of continuing to operate the plant for 5 years.
In light of the information given in the problem, calculating the annual cash flow is not the correct way to approach this problem. To answer this question, first calculate the immediate (Year 0) cost to shut down the plant, and then compare that with the net present value of continuing to operate the plant for 5 years.
To answer this question, first calculate the immediate (Year 0) cost to shut down the plant, and then compare that with the net present value of continuing to operate the plant for 5 years. The immediate cost to shut down the plant is the net present value (negative) of that option. Both that and the net present value of continuing to operate the plant will be negative and so will be losses; but the net present value of one option will be a smaller loss than the net present value of the other option. Shut down option – immediate (Year 0) costs: Labor contract: $(1,500,000) Default on customer contract: $(500,000) Cash from sale of plant: $750,000 Net cash flow from shutting down as of Year 0, which is also the net present value of shutting down: $(1,250,000) loss. Note: Since this loss occurs at Year 0, it does not need to be discounted. Operate for 5 years option: Annual cash flow from operations: Contribution margin 150,000 × ($100 ? $75): $3,750,000 per year Fixed costs: 4,000,000 per year Loss per year: $(250,000). The discount rate is 12%. The PV of an Annuity factor for 12% for 5 years is 3.605. The PV of an annuity of $(250,000) for 5 years at 12% is $(250,000) × 3.605 = $(901,250). The net present value of shutting down the plant is $(1,250,000). The net present value of operating for 5 years is $(901,250). The difference is $348,750. The incremental net present value (difference between the two net present values) is approximately $350,000. The company would be better off continuing to operate the plant for 5 years because it would lose a present value of $901,250 by doing so, as compared to losing a present value of $1,250,000 if they shut the plant down immediately.