Question

At the end of 2015, Uma Corporation is considering undertaking a major long-term project in an effort to remain competitive in its industry. The production and sales departments have determined the potential annual cash flow savings that could accrue to the firm if it acts soon. Specifically, they estimate that a mixed stream of future cash flow savings will occur at the end of the years 2016 through 2021. The years 2022 through 2026 will see consecutive and equal cash flow savings at the end of each year. The firm estimates that its discount rate over the first 6 years will be 7%. The expected discount rate over the years 2022 through 2026 will be 11%. The project managers will find the project acceptable if it results in present cash flow savings of at least $860,000. The following cash flow savings data are supplied to the finance department for analysis.

a. Determine the value (at the beginning of 2016) of the future cash flow savings expected to be generated by this project.

b. Based solely on the one criterion set by management, should the firm undertake this specific project? Explain

c. What is the "interest rate risk," and how might it influence the recommendation made in part b?

Explain. End of year Cash flow savings

2016 $ 110,000.00

2017 120,000.00

2018 130,000.00

2019 150,000.00

2020 160,000.00

2021 150,000.00

2022 90,000.00

2023 90,000.00

2024 90,000.00

2025 90,000.00

2026 90,000.00

Answer 1

a.

b. Based solely on the one criterion set by management, the firm should not acccept this project as the expected cash flow savings is $820,036.49 , while the management expects a cash flow savings of $ 860,000.

c. The discount rate is 7% for the first 6 years of the project. However 7th year onwards there is a 4% increase and the new rate is 11%. This higher discount rate reduces the discounted cash flows.

If the interest rate had remained same i.e. 7%, the total of discounted cash flow would have been $ 888,090.64, higher than $ 860,000 and the project could have been accepted.