Question

Truman Industries, Inc. (TI) is considering a capital budgeting project. The appropriate discount rate for this project is 4%. The initial cost of the project will be $350,000. The project is expected to produce positive after tax cash flows of $140,000 per year for the next 6 years. Winding up of the project will produce an additional after tax positive cash flow of $200,000 in the sixth year. What are the NPV, IRR and payback for the project? Should this project be accepted? Why or why not?

Answer 1

1.

NPV = $541,962.07

2.

IRR = 37.1873%

3.

Payback period = 2.50 years

4.

Accept the project

As NPV is significantly positive, we should accept the project. IRR is higher than cost of capital or discount rate of the project and we have a Payback period of 2.5 years

Working for NPV, IRR and Payback period below:

NPV = $541,962.07

		Discount rate = WACC = R = 4%	Present Values
Year	Cash flows	Discount factor or PV factors = Df = 1/(1+R)^Year	PV of cash flows = Cash flows x Df
0	-$350,000.00	1.000000	-$350,000.00
1	$140,000.00	0.961538	$134,615.38
2	$140,000.00	0.924556	$129,437.87
3	$140,000.00	0.888996	$124,459.49
4	$140,000.00	0.854804	$119,672.59
5	$140,000.00	0.821927	$115,069.79
6	$340,000.00	0.790315	$268,706.94
		Total of Present values = NPV =	$541,962.07

IRR = 37.1873%

IRR is obtained with trial error. We have to fix rate such that we get NPV = 0 or near to zero. At

		Discount rate = R = 37.1873%	Present Values
Year	Cash flows	Discount factor or PV factors = Df = 1/(1+R)^Year	PV of cash flows = Cash flows x Df
0	-$350,000.00	1.000000	-$350,000.00
1	$140,000.00	0.728930	$102,050.26
2	$140,000.00	0.531340	$74,387.54
3	$140,000.00	0.387310	$54,223.35
4	$140,000.00	0.282322	$39,525.05
5	$140,000.00	0.205793	$28,811.01
6	$340,000.00	0.150009	$51,002.97
		Total of Present values = NPV =	$0.18

Payback period = 2.5 years

Year	Cash flows	Cumulative cash flow
0	-$350,000.00	-$350,000.00
1	$140,000.00	-$210,000.00
2	$140,000.00	-$70,000.00
3	$140,000.00	$70,000.00
4	$140,000.00	$210,000.00
5	$140,000.00	$350,000.00
6	$340,000.00	$690,000.00

Payback period = A + |B|/C                                                   

A = Last period with a negative cumulative cash flow                                                 

|B| = Absolute value of cumulative cash flow at end of period A                                            

C = Total cash flow during the period after A                                                  

                                                         

Payback period = 2+|-70000|/140000 = 2+70000/140000 = 2.50                                           

Payback period = 2.50 years