Question

Financial Management

Chapter 10 Case

1. Warren Lynch at CompU has calculated the cash flows for the advertising campaign, and now has to decide whether the ad campaign will generate more cash flows than its cost. The cash flows for the campaign are as follows. CompU’s cost of capital is 9%.

Initial Investment: $110,000

Operating Cash Flows by year:

Year                      Cash Flows

1                            $35,000

2                            $39,800

3                            $34,600

4                            $31,800

5    $31,800

1. Calculate the payback period of the ad campaign.
2. Calculate the net present value of the campaign.
3. Calculate the internal rate of return of the campaign. Should the campaign be accepted?

2. CellU, a subsidiary of CompU, is looking to replace one of the machines they use to manufacture cell phones with a new, more efficient model. The incremental cash flows of the new machine are as follows. CellU’s cost of capital is 11%.

Initial Investment: $12,190

Operating Cash Flows by year:

Year                      Cash Flows

1                            $4,974

2                            $5,760

3    $4,320

1. Calculate the payback period of the new machine.
2. Calculate the net present value of the new machine.
3. Calculate the internal rate of return of the new machine. Should the machine be accepted?

Answer 1

1.a.Payback period is the time period taken to recover the initial cost of investment and it is calculated using the formula below:

Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

Payback period= 3 years + $600/ $31,800

                              = 3 years + 0.02

                              = 3.02 years.

b. Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -110,000.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the third cash flow cash flow, press the NPV button and enter the interest rate of 9%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value of cash flows of the campaign is $25,522.24.

1.Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -110,000.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 17.84%.

The project should be accepted according to the net present value rule since the campaign has a positive net present value. It should also be accepted according to the internal rate of return rule since the internal rate of return computed is higher than the cost of capital.

2.a.Payback period=full years until recovery + unrecovered cost at the start of the year/cash flow during the year

Payback period= 2 years + $1,456/ $12,190

                              = 2 years + 0.1194

                              = 2.02 years.

b. Net present value is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -12,190
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the interest rate of 11%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.

The net present value of cash flows of the new machine is $124.77.

Internal rate of return can be calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -12,190
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR button and enter the interest rate to get the IRR of the project.

The IRR is 11.5994% 11.60%.

The new machine should be accepted since according to the net present value rule, the new machine has a positive net present value. It should also be accepted according to the internal rate of return rule since the internal rate of return computed is higher than the cost of capital.