Question

As we’ve examined in prior class periods, CIC is currently considering expanding operations. The first expansion plan—which we’ve worked on in a previous class—calls for the purchase of a physical location, remodeling of that location, and purchase of a freezer. The freezer would cost $4,289, have an estimated useful life of 7 years, and have a salvage value of $300. Purchase of the freezer would allow CIC to use the new building as a retail space.

In addition to that opportunity, CIC is also considering purchasing the building, but using it only as a center of operations (rather than as retail space). As a result, CIC would remodel the space, but purchase of the freezer would not be necessary. Instead, CIC would purchase a small ice cream stand. The stand would cost $7,000, have an estimated useful life of 7 years, and have no salvage value.

Both options would require additional working capital of $500, which will be recovered at the end of the life of each option.

Assume that CIC’s cost of capital is 8%.

Details about the operating cash flow for each year are below.

	Purchase freezer	Purchase stand
Estimated cash outflow per year	$9,000	$12,000
Estimated cash inflow:
Year 1	$9,600	$13,390
Year 2	$9,676	$13,390
Year 3	$9,761	$13,390
Year 4	$9,857	$13,390
Year 5	$9,965	$13,390
Year 6	$10,086	$13,390
Year 7	$10,223	$13,390

Compute the following for each option:

1. Net present value

2. Internal rate of return. For the sake of simplicity, for this computation only, (1) utilize the average net operating cash flow per year for the freezer purchase ($881.14) and (2) ignore working capital and salvage values for both options.

3. Present value index

4. Payback period

Based on your analysis, which option would you recommend that CIC pursue?

In the above analysis, we only considered differences between the freezer and stand. Why didn’t we include information about the building or remodeling?

Answer 1

a) net present value.

freezer

year	cash inflow	cash outflow	cash flow	pv factor8%	present value of cash flow	accept/reject
1	9600	9000	600	0.925	555
2	9676	9000	676	0.857	579.332
3	9761	9000	761	0.793	603.473
4	9857	9000	857	0.735	629.895
5	9965	9000	965	0.680	656.2
6	10086	9000	1086	0.630	684.18
7	10223	9000	1223	0.583	713.009
				total pv	4,421.089
				cost	(4289)
				npv	132.089	reject(purchase stand has more npv than freezer)
			given cash flow = 881.14	irr cashflows/(1+r)i-initial investment.	10%	accept because if irr more it is better to company
				present value index= pv/initial investment = 4421.089/4289	1.03	in noth cases it is same accept
				pay back period = initial investment/cash flow = 4289/1223	3.50	pay back period is high so reject the project

purchase stand

year	cash inflow	cashoutflow	cash flow	pv factor	present value of cash flow	accept/reject
1	13,390	12000	1390	0.925	1285.75
2	13,390	12000	1390	0.857	1191.23
3	13,390	12000	1390	0.793	1102.27
4	13390	12000	1390	0.735	1021.65
5	13390	12000	1390	0.680	945.2
6	13390	12000	1390	0.630	875.7
7	13390	12000	1390	0.583	810.37
total			97309730		7,232.17
cost					(7000)
				npv	232.17	accept
				irr (1390)/(1.08)7-7000	9%	reject irr is lower than purchase freezer
				present value index = 7232.17/7000	1.03	accept
				pay back period= initial investment/ cash flows 7000/9730	0.71	accept pay back period is low we can accept the project.

ignore salvage value and working capital for both option.