Question

With an initial outlay of $115,000, Goldie’s Retreat is researching an expansion of their bed-n-breakfast by offering a Sunday brunch. The owner expects to see their money returned within 4 years and estimates an expected rate of return of 6%. With the following projected free cash flows, should the owner proceed with the investment? Use NPV and IRR to explain your answer.

IO = -$115,000

FCF Year 1 = $50,000               

FCF Year 2 = $25,000               

FCF Year 3 = $15,000       

FCF Year 4 = $12,000

A. NPV = ______

B. IRR = _______

C. Should they proceed with the investment and why. _____________________

Answer 1

A	Computation of NPV
	Expected Rate of Return = 6 %
	Year	Cashflows	PVF at 6%	PV
A	0	$      (115,000)	1.0000	$       (115,000)
		PV of Cash Outflows		$       (115,000)
B	1	$          50,000	0.9434	$      47,169.81
	2	$          25,000	0.8900	$      22,249.91
	3	$          15,000	0.8396	$      12,594.29
	4	$          12,000	0.7921	$        9,505.12
		PV of Cash Inflows		$      91,519.14
C	NPV	= B-A		$    (23,480.86)

B.

Computation of IRR
Expected Rate of Return = 5 %
Let us Discount the cashflows at -7%
Year	Cashflows	PVF at -7%	PV
0	$ (115,000)	1.0000	$        (115,000)
	PV of Cash Outflows		$        (115,000)
1	50000	1.0753	$       53,763.44
2	25000	1.1562	$       28,905.08
3	15000	1.2432	$       18,648.44
4	12000	1.3368	$       16,041.67
	PV of Cash Inflows		$    117,358.62
NPV	= B-A		$         2,358.62

The Present Value of Cash Inflows at -7 % are more than Initial Cash Outflow.

There higher discount rate is suggested, say -6%

	Year	Cashflows	PVF at -6%	PV
A	0	$      (115,000)	1.0000	$       (115,000)
		PV of Cash Outflows		$       (115,000)
B	1	$          50,000	1.0638	$      53,191.49
	2	$          25,000	1.1317	$      28,293.35
	3	$          15,000	1.2040	$      18,059.58
	4	$          12,000	1.2808	$      15,369.86
		PV of Cash Inflows		$    114,914.27
C	NPV	= B-A		$            (85.73)

Using Interpolation,

IRR = [-7 +($ 117,358.62-$ 115,000)/ ($ 117,358.62-$ 114,914.27)]*(-6-(-7))

IRR = (6.04) % or -6.04%

C. No, they should not proceed with the investment. Because the NPV is negative i.e., the present value of cash outflows are higher than present value of cash inflows;

The IRR of the Project is -6.04%, while the expected Rate of return is 6%.

As both NPV and IRR of the project ar negative, The owner should not proceed with the investment.