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 $102,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 5 percent per year forever. The project requires an initial investment of $1,550,000.

a-1 What is the NPV for the project if the company's required return is 10 percent?

a-2  f the company requires a return of 10 percent on such undertakings, should the cemetery business be started? Yes or No?

b. The company is somewhat unsure about the assumption of a growth rate of 5 percent in its cash flows. At what constant growth rate would the company just break even if it still required a return of 10 percent on investment?

Answer 1

Given that the annual cash flows will grow at a rate of 5%

We know the the net present value is nothing but the present value of cash inflow reduced with the present value of cash out flow discounted at the required rate of return

Accordingly, We will first discount the cash inflows

This is in the form of growing perpetuity

The formula to calculate the value of growing perpetuity is

A/(Re-g)

Where A is the upcoming cash inflow in year-1

Re is the required rate of return

G is the growth rate

Accordingly the present value = 102,000/(0.1 - 0.05)

= 102,000/0.05

= 20,40,000

hence the present value of cash inflows =  20,40,000

Given the initial investment = 1,550,000

Hence the NET PRESENT VALUE = 20,40,000 - 1,550,000 = $4,90,000

Here the net present value is positive that means the project is going to generate wealth to the company and share holders hence the project can be accepted.

Now we will use the present value of growing annuity formula inorder to find out the the required rate of growth

Inorder to break even the present value of cash inflows should be equal to present value of cash outflows

Hence, 1,550,000 = 102,000/ (0.1 - g)

Hence 1,550,00 - 1,550,000g = 102,000

53000/1550000 = g

g = 3.419355

Hence the required growth rate should be 3.419355%