Question

1. Fijisawa Inc. is considering a major expansion of its product line and has estimated the following cash flows associated with such an expansion, the initial outlay would be $1,900,000 and the project would generate cash flows of $450,000 per year for six years, the appropriate discount rate is 9%.

   1. Calculate the net present value.

   2. Calculate the profitability index.

   3. Calculate the internal rate of return.

   4. Should this project be accepted? Why or why not?

Answer 1

Initial Outlay = $1,900,000
Annual Cash Flows = $450,000
Useful Life = 6 years

Answer a.

Present value of cash flows = $450,000/1.09 + $450,000/1.09^2 + $450,000/1.09^3 + $450,000/1.09^4 + $450,000/1.09^5 + $450,000/1.09^6
Present value of cash flows = $450,000 * (1 - (1/1.09)^6) / 0.09
Present value of cash flows = $2,018,663.37

Net present value = Present value of cash flows - Initial outlay
Net present value = $2,018,663.37 - $1,900,000.00
Net present value = $118,663.37

Answer b.

Profitability index = Present value of cash flows / Initial outlay
Profitability index = $2,018,663.37 / $1,900,000.00
Profitability index = 1.06

Answer c.

Let IRR be i%

Net present value = -$1,900,000 + $450,000/(1+i) + $450,000/(1+i)^2 + $450,000/(1+i)^3 + $450,000/(1+i)^4 + $450,000/(1+i)^5 + $450,000/(1+i)^6
0 = -$1,900,000 + $450,000/(1+i) + $450,000/(1+i)^2 + $450,000/(1+i)^3 + $450,000/(1+i)^4 + $450,000/(1+i)^5 + $450,000/(1+i)^6

Using financial calculator, i = 11.07%

Internal rate of return = 11.07%

Answer d.

This project should be accepted as its NPV is positive, Profitability index is higher than 1.00 and IRR is higher than discount rate.