Question

Cardinal Company is considering a five-year project that would require a $2,860,000 investment in equipment with a useful life of five years and no salvage value. The company’s discount rate is 14%. The project would provide net operating income in each of five years as follows:

Sales			$	2,859,000
Variable expenses				1,100,000
Contribution margin				1,759,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	700,000
Depreciation		572,000
Total fixed expenses				1,272,000
Net operating income			$	487,000

2-a. What are the project’s annual net cash inflows?

         

2-b. What is the present value of the project’s annual net cash inflows? (Round discount factor to 3 decimal places.)

3. What is the project’s net present value? (Round discount factor(s) to 3 decimal places and final answer to the nearest whole dollar amount.)

  

What is the project profitability index for this project? (Round discount factor(s) to 3 decimal places and final answer to 2 decimal places.)

Thank you

Answer 1

Question 2a:

To find the annual net cash inflows we need to make some adjustments to the net income given in the question just like in the "indirect method" of a cash flow statement. Here, the only adjustment required to be made is to add back the non cash expense of depreciation.

Net annual cash inflows= Net operating income + Depreciation= 487000+572000= $1059000

Since the tax applicability has not been mentioned in the question, the tax impact has been ignored.

Question 2b:

Present value of the project’s annual net cash inflows can be found out by multiplying the yearly net annual cash inflows with the corresponding discount factor for that year at the discount rate of 14%. Here, since the yearly cash flows are same, we need only multiply the yearly net annual cash inflows with the cumulative discount factor for the the useful life of the project which is five years. Also there is no salvage value for the project and therefore no adjustments have to be made in the last year in the net cash inflow of last year for salvage value.

Cumulative factor for five years= 0.877+0.769+0.675+0.592+0.519= 3.432 (refer to the present value table for the discount factors and add them up)

Present value of the project’s annual net cash inflows= 1059000*3.432= $3634488

Question 3a:

NPV of a project is the difference between the Present value of the project’s annual net cash inflows and the total initial cash outlay. If npv is positive the project must be selected, if it is negative the project must be rejected.

NPV= Present value of the project’s annual net cash inflows- Initial cash outlay= 3634488- 2860000= $774488

The Project should be accepted.

Question 3b:

Profitability is the ratio of Present value of the project’s annual net cash inflows divided by the initial cash outlay. If it is greater than one, the project must be selected. If not, it should be rejected.

Profitability index= Present value of the project’s annual net cash inflows/ initial cash outlay= 3634488/2860000= 1.2708

The project should be accepted.