Question

Dow Chemical Inc.is considering investing in a project that will cost $152,000 and have no salvage value at the end of its 5-year life. It is estimated that the project will generate annual cash inflows of $40,000 each year. The company has a hurdle or cutoff rate of return of 9%.

Instructions

1. Using the internal rate of return method calculate an approximate interest yield for the project. (use tables from Appendix G)
2. Should this project be accepted by Dow Chemical and why?

Answer 1

a)

Initial investment in project = $152000

Salvage value at the end of life = Nil

Maturity = 5 years

Annual cash inflows = $40000

Hurdle rate = 9%

IRR is the rate at which Present value of cash inflows is equivalent to present value of cash outflows:

Present value of cash inflows = $152000

$40000*Present value annuity factor(r,5) = $152000

Present value annuity factor(r,5) =  $152000/$40000

Present value annuity factor(r,5) = 3.8

Now we have find out the value of r whose annuity value is 3.8 for 5 years.

So, we take r = 10% then annuity value for 5 years of 10% is 3.79.

So, IRR = 10% (approximatey)

Approximate yield for the project is 10%.

b)

Present Value of Cash inflow = Annual cash inflow * Present value annuity factor(9%,5)

= 40000*3.89 = $155600

Initial Cash investment = $152000

Net present value = Present Value of Cash inflow - Initial Cash investment =  $155600 - $152000 = $3600

This project should be accepted by Dow chemical because net present value of this project is positive and IRR of this project is also greater than cutoff rate of return.