Question

Costco, Inc. is conducting a new project with the following estimated cash flows. The initial outlay is estimated to be ​$1,950,000​, and the incremental cash flows generated by this project would be ​$650,000 per year for 7 years. The estimated required rate of return of the project is 6​%.

a. Calculate the NPV.

b. Calculate the PI.

c. Calculate the IRR.

d. Should this project be​ accepted?

Answer 1

Part A:

NPV :
NPV = PV of Cash Inflows - PV of Cash Outflows
If NPV > 0 , Project can be accepted
NPV = 0 , Indifference point. Project can be accepted/ Rejected.
NPV < 0 , Project will be rejected.

Year	CF	PVF @0.06	Disc CF
0	$ -19,50,000.00	1.0000	$ -19,50,000.00
1	$     6,50,000.00	0.9434	$     6,13,207.55
2	$     6,50,000.00	0.8900	$     5,78,497.69
3	$     6,50,000.00	0.8396	$     5,45,752.53
4	$     6,50,000.00	0.7921	$     5,14,860.88
5	$     6,50,000.00	0.7473	$     4,85,717.81
6	$     6,50,000.00	0.7050	$     4,58,224.35
7	$     6,50,000.00	0.6651	$     4,32,287.12
NPV	$ 16,78,547.94

Part B:

Profitability Index:

PI = PV of Cash inflows / PV of Cash Outflows

If PI > 1, Project will be accepted,

PI = 1, Indifference point. Project will be accepted/ Rejected.

PI < 1, Project will be rejected.

Year	CF	PVF @0.06	Disc CF
1	$ 6,50,000.00	0.9434	$      6,13,207.55
2	$ 6,50,000.00	0.8900	$      5,78,497.69
3	$ 6,50,000.00	0.8396	$      5,45,752.53
4	$ 6,50,000.00	0.7921	$      5,14,860.88
5	$ 6,50,000.00	0.7473	$      4,85,717.81
6	$ 6,50,000.00	0.7050	$      4,58,224.35
7	$ 6,50,000.00	0.6651	$      4,32,287.12
PV of cash Inflows	$   36,28,547.94
PV of cash Outflows	$   19,50,000.00
Profitability Index:	1.86

Part C:

IRR :
IRR is the Rate at which PV of Cash Inflows are equal to PV of Cash Outflows.

IRR = Rate at which least +ve NPV + [ NPV at that Rate / Change in NPV due to 1% inc in disc rate ] * 1%

If IRR > Cost of Capital - Project can be accepted
IRR = Cost of Capital - Indifferebce Point - Project will be accepted / Rejected
IRR < Cost of Capital - Project will be erejected

Year	Cash Flow	PVF/[email protected]	PV of Cash Flows	PVF/[email protected]	PV of Cash Flows
1-7	$       6,50,000.00	3.0087	$             19,55,631.00	2.9370	$          19,09,060.02
PV of Cash Inflows	$            19,55,631.00		$         19,09,060.02
PV of Cash Oiutflows	$            19,50,000.00		$         19,50,000.00
NPV	$                    5,631.00		$             -40,939.98

PVAF = Sum [ PVF(r%, n) ]

PVF (r%, n) = 1 / ( 1 + r)6n

r = Disc rate

n = Time gap

IRR = Rate at which least +ve NPV + [ NPV at that rate / Change in NPV due to Inc of 1% in Int Rate ] * 1%

= 0.27 + [5631 / 46570.98 ] * 1%

= 0.27 + [0.12 ] * 1%

= 0.27 + [0.0012]

= 0.2712

Part D:

Project can be accepted as NPV >0, PI >1 & IRR > Cost ofcapital.

Pls do rate, if the answer is correct and comment, if any further assistance is required.