Question

The Yurdone Corporation wants to set up a private cemetery business. According to the CFO, Barry M. Deep, business is "looking up". As a result, the cemetery project will provide a net cash inflow of $107,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 3 percent per year forever. The project requires an initial investment of $1,600,000.

  

a-1	What is the NPV for the project if the required return is 12 percent? (A negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

    

a-2	If the company requires a return of 12 percent on such undertakings, should the firm accept or reject the project?
	Reject Accept

  

b.

The company is somewhat unsure about the assumption of a growth rate of 3 percent in its cash flows. At what constant growth rate would the company break even if it still required a return of 12 percent on investment? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

    

Answer 1

Q1 a) Given : discount rate = 12%

Perpetual growth = 3%

Initial investment = $ 1,600,000

Cash flow = $ 107,000

Npv = ?

Therefore Npv for contant growth is calculated by using perpetual growth formula of present value.

Present value = cash inflow/ ( discount rate - growth rate)

Putting in the value :  

Present value = $107,000/ ( 0.12- 0.03)

= $107,000/0.09

= $ 1,188,888.89

Hence,

Npv = -(Initial investment) + Present value of cash inflow

= -1,600,000 - 1,188,888.89

= - $411,111.11

Q2 a) The firm should reject the project because Npv is negative.

b) Break even is a point where cost and revenue is equal to 0.

Therefore to find the growth rate at which break even will take place, we will equate initial investment with cash inflow.

Initial investment = cash inflow/ (discount rate - growth rate)

1,600,000 = 107,000/ (0.12 - growth rate)

Rearranging the equation, we get

0.12 - growth rate = 107,000 / 1,600,000

0.12 - growth rate = 0.0669

Growth rate = 0.12 - 0.0669

Growth rate = 0.0531

= 5.31%

Hence, the growth rate should be 5.31% to reach break even.