Question

A proposed project will generate £150,000 in revenue a year for 20 years (starting next year), but will cause another product line to lose £60,000 in revenue a year during that time. The project will make use of 50% of an already leased warehouse with total annual rent of£50,000 (the contract does not prohibit sub-leasing). The discount rate for this project is 6%. Should the firm undertake this project if the required investment is £250,000? What is the Payback Period for this project?

Answer 1

Solution:-

                        Incremental annual cash inflows=cash inflows -loss in revenue                                                                                        due to the project

                                                                                    = £150,000- £60,000

                                                                   = £90,000

Note:- The 50% rent of the warehouse is to be ignored as it is already being incurred and there is no change in cash flows due to this decision.

NPV of the project = PV of inflows- PV of outflows

                             = £90,000×PVIFA(6%,20years)- £250,000

                             =£90,000×11.4699-£250,000          

                             =£782,291

Recommendation:- Since the NPV of the project is positive hence we                                   should accept the project.

b) Calculation of pay back period

          Pay back period =Initial outflows/Annual equal inflows

                                    =£250,000/£90,000

                                   =2.78 years