Question

Woodbridge Manufacturing case in Appendix E, and use the three primary project evaluation methods (NPV, IRR and Payback) to determine the acceptability of this capital expenditure project. The cost of the new equipment to build a new product, including shipping and installation, (the initial investment outlay) is $100,000. The net additional receivables and inventory needed to support sales of the new project of $12,979 is scheduled to be incurred during year 1. (Side note: This is a little unusual. Generally these costs are incurred at time 0.) The new product is expected to have a five year life, and during that time the sum of the additional gross margin over and above what the previous product earned, plus the tax savings from the greater depreciation (the supplemental annual cash flows) amounts to $38,875 each year. In addition, the $14,469 in additional receivables and inventory (included in the net $12,979 year 1 investment outlay) will be recovered at the end of year 5 (the terminal value). (Second side note: You may ask, how can they recover more in receivables and inventory than they invested in the first place? The answer is the original amount is the net between what was invested for this new project ($14,469) and what had been already invested in the prior project ($1, 940)). In this case there was no salvage value on the machine that was used for the project, but if there were, the net after-tax cash flow from the salvage value would also be included in the terminal value. The Treasury Department at your company tells you the appropriate weighted average cost of capital (the discount rate) is 10% for this type of project. Calculate the NPV and state whether, from a financial standpoint, this project would be acceptable based on the NPV criteria. Calculate the IRR and Payback. What do these methods indicate as far as the acceptability of the project?

1) The marketing manager feels the total supplemental annual cash flows over the five years of the project were good at $194,375, but felt the adoption rate would likely be much faster, resulting in a cash flow profile of $38,875 in year 1, $77,750 in year 2, $38,875 in year 3, $29,200 in year 4 and $9,675 in year 5. How do these changes affect the project evaluation measures and acceptability?

The controller feels that the adoption rate would likely be much slower, resulting in a cash flow profile of $9,675 in year 1, $29,200 in year 2, $38,875 in year 3, $77,750 in year 4 and $38,875 in year 5. How do these changes affect the project evaluation measures and acceptability?

The company Treasury Department decides that the discount rate should be increased to 15%, based on a closer evaluation of the risks of the project. Going back to the original cash flow profile, what affect does this change have on the project return and its acceptability?

From these examples, sum up what you have learned about the NPV project evaluation method. What general rules can you draw from these calculations and results?

Answer 1

year	cash flow	negative flow	positive flow
0	-100000	-100000
1	25896	-12979	38875
2	38875		38875
3	38875		38875
4	38875		38875
5	53344	14469	38875

npv	payback	irr
44551.85	2.906 years	24.5%

this project will be accepted as it has positive NPV & adds value for the company

1.

year	total cash flow	negative flow	positive flow
0	-100000	-100000
1	25896	-12979	38875
2	77750		77750
3	38875		38875
4	29200		29200
5	24144		24144

npv	payback	irr
₹ 51,940.90	1.953 years	30.2%

this project will also be accepted as it has +ve NPV & good IRR lower payback period

2.

year	cash flow	negative flow	positive flow
0	-100000	-100000
1	-3304	-12979	9675
2	29200		29200
3	38875		38875
4	38875		38875
5	53344	14469	38875

npv	payback	irr
₹ 10,010.00	3.906	12.9%

although lower NPV compared to other projects it will still be accepted. but in comparison 1. is much better.

In original cash flow profile situation if WACC increased to 15%

year	cash flow	negative flow	positive flow
0	-100000	-100000
1	25896	-12979	38875
2	38875		38875
3	38875		38875
4	38875		38875
5	53344	14469	38875

npv

₹ 26,222.59

overall conclusion - the timing of cash flows is important in calculation of NPV. If higher positive cash flow is recieved early on then the NPV is higher compared to where cash flow is recieved in later period. If IRR & NPV conflicts use NPV ALWAYS