Question

Ella, Inc. is considering a new capital budgeting project (the “Investment”). The Investment will cost $102,030 that must be invested today, and $105,000 that must be invested at the end of year one. The Investment will have the following net cash inflows at the end of each of the next three years. Year 1: $50,000; Year 2: $75,000; and Year 3: $100,000. The financial accounting net operating income for each of the next three years is as follows: Year 1: $25,000; Year 2: $50,000; and Year 3: $75,000 Assume all cash flows, except for the initial investment, occur at the end of the year. Ella’s cost of capital (discount rate) is 5% per year. Use the formula (or a financial calculator) to calculate the present value of $1, and not the factors as shown in the table in Chapter 25 of your text, which do not show the factors for 5%. For instance, the factor for the present value of $1 at the end of one period at 5% is calculated as: 1 / (1+.05) 1, which equals 0.952381. At 5%, for period two the factor is 0.907029, and for period 3 the factor is 0.863838. 1. What is the Payback Period? ____________ 2. What is the Present Value of the Investment’s Cash Outflows? ___________________ 3. What is the Net Present Value of the Investment? ___________________ 4. What is the Investment’s Internal Rate of Return? ___________ 5. Should Ella, Inc. invest? _____ Explain why or why not? ____________________________________________________________________________________________________________________________________

Answer 1

1) Payback period is basically and undiscounted technique to find out the time by which initial investment is recovered. Lower payback is prefered.

Closing balance = Opening balance + Investment - CF

Opening balance of one period is the closing balance of the previous period.

We see that at the end of the year 2 the closing balance is of 82030 but at the end of year 3 it is -17970 which implies that some time during the year 3, entire investment is recovered. We assume that entire CF is generated uniformly throughout the year and therefore the payback period is calculated as follows:

2)In the year 0 there is an investment of 102030 and in the year 1 there is an investment of 105000 so the discounted value of total investment at 5% discount rate:

3) Following Screenshot shows how to calculate the NPV :

So NPV equation:

4) IRR is basically that rate which when used to discount the CF's there sum is equal to the initial cash investment leading to an NPV of 0.

So IRR equation

Which is logical too from the NPV equation as at 5% discount rate, the NPV was close to 0 so with a slightly higher discount rate, as calculated above, NPV will be 0

5)As the project has a positive NPV it should be accepted but as the NPV is neglegible, i.e. very close to 0 we can say that this project is a no profit no loss situation and therefore investing or not investing will not make much of a difference so this is not a very lucrative investment.