Question

Management of Lakeside, Inc. is considering an investment in an expansion of the company's                product line. The estimated investment required will be $162,500. You can assume that the full amount will be invested at the beginning of 2013. The estimated cash returns from the new product line are shown in the following table. You should assume that the returns are received at the end of each of the years indicated, and that Lakeside, Inc.’s cost of capital is 12%.

Year	Estimated Cash Return
2016	$36,000
2017	48,000
2018	60,000
2019	72,000

Calculate the present value of the cash returns. Show the present value factors and amounts in the space to the right of the cash returns in the above table.                                                                    

    

Calculate the net present value of the investment.

Calculate the profitability index of the investment.

Estimate, but do not calculate, the Internal Rate of Return of the product line expansion.

Calculate the payback period of the investment.

Based on your quantitative analyses, would you recommend that the product line expansion project be undertaken?

Identify some qualitative factors that you would want to consider with respect to this investment.

Answer 1

1. Presnt Value

Year	Estimated Cash Return	PV Factor i=12%	Present Value $
2016	36000	0.8929	32144.4
2017	48000	0.7972	38265.6
2018	60000	0.7118	42708
2019	72000	0.6355	45756
	Total Present Value		158874

2. Net Present Value = -$162500 + $158874 = -$3626

3. Profitability Index = PV of estimated future cash flows/Initial Investment = $158874/$162500 = 0.98

4. Since at 12% the NPV is negative, the estimated Internal Rate of Return is lower than 12%, say around 11%.

5. Payback period

Year		Estimated Cash Return	Cumulative cash flow
0	Beg. 2016	-162500	-162500
1	2016	36000	-126500
2	2017	48000	-78500
3	2018	60000	-18500
4	2019	72000	53500

Payback period = 3 + (18500/72000) = 3 + 0.2569 = 3.26 years

6. Looking at the various quantitiative analysis techniques used, it is seen that the net present value for the investment is negative, profitability index is less than 1, IRR is lower than the cost of capital and the payback period is near the end of life of the project. In view of the same, the product line expansion project should not be undertaken.

7. Some qualitative factors that may be considered are the quality of the new product to be manufactured with the investment, time and delivery issues, markets and competition, social factors such as new employment generation, environmental issues if any due to new product line.