Question

Case Analysis 1: You work for a small, local telecommunications company. In five years, the company plans to undertake a major upgrade to its servers and other IT infrastructure. Management estimates that it will need up to $450,000 to cover all related costs; however, as a fairly young company, the goal is to pay for the upgrade with cash and not to take out loans. Right now, you have $300,000 in a bank account established for Capital Investments. This account pays 4% interest, compounded annually. A member of the finance department has approached you with an investment opportunity for the $300,000 that covers a five-year period and has the following projected after-tax cash flows:

Year Projected Cash Flow

1 $90,000

2 $115,000

3 $135,000

4 $110,000

5 $90,000

Based on this information, in an MS Word document, answer the following questions:

1) How much money will be in the bank account if you leave the $300,000 alone (earning 4% compounded interest) until you need it in five years?

2) If you undertake the investment opportunity, what is the Nominal Payback Period?

3) Using the Present Value factors for 7% (which can be found on any PV Factor table), what is the discounted Payback Period of the investment opportunity?

4) What is the Net Present Value at 7% of the investment opportunity?

5) Which option (make the investment or leave the money in a savings account) would you recommend to your CEO? Why? What additional factors/information might make you change your point of view?

Answer 1

1.Principal = 300,000

Interest = 4% compound interest

Value after 5 years = 300,000(1+0.04)⁵

=$364,995.87

2. Nominal Payback period is the time period in which the initial investment is recovered

Outflow = 300,000

Year	Cash Flow	Cumulative Cash Flows
1	90,000	90,000
2	115,000	205,000
3	135,000	340,000
4	110,000	450,000
5	90,000	540,000

Payback period will lie between 2 and 3 years

Payback Period = 2 + 95,000/(340,000-205,000)

=2.70 years

Discounted Payback Period: Discounted Cash Flows are taken in place of nominal cash flows.

Year	Cash Flows	PVF@7%	PV of Cash Flows	Cum. Cash Flows
1	90,000	0.935	84,150	84,150
2	115,000	0.873	100,395	184,545
3	135000	0.816	110,160	294,705
4	110,000	0.763	83,930	378,635
5	90,000	0.713	64,170	442,805

Discounted payback Period = 3 + (300,000-294705)/(378635-294705)

=3.06 years

4. Net Present Value = Present Value of Cash Inflow – Present Value of Cash Outflows

=422,805-300,000 = $142,805

5. Investment in the project is recommended, since Profit is more than what we will get in the savings account. Risk Associated with the project might change my view. If the Cash Flows are risky and uncertain in the project, I might want to go with the safe 4% interest in the savings Account