Question

2. Decision-Making Problem You are the financial manager of “Go Dolphins”, a corporation that sells sports accessories. Anticipating the victory of the Miami football team next season, the corporation is thinking in introducing a new line of accessories for kids to increase its market share. Management is considering buying the following machine as part of the strategic plan to gain market share.

Machine: XBP 300

Cost and Installation Costs: $200,000

Additional Capital Investment: Supplies and others, $50,000

The machine should bring a $60,000 cash flow for its first year of operation. After that, cash flows are expected to increase at a rate of 10% a year for the next four years. On year five the machine will be sold for its salvage value, $20,000. Management believes that the rate of return of this project should be 12% due to the risks involved. No additional capital investments will be required during the project life.

Calculate the following:

a. Total Initial Investment

b. Total Cash Flows from years 1 to 5*

c. NPV and IRR

d. Decide if it is a good investment. Explain your answer using NPV and IRR

*Hint: The amount from the sale of the machine on year 5 is considered a cash inflow for that year.

Answer 1

a) Step 1: Calculation of Total Initial Investment

Cash Outflows	Amount ($)
Cost of Machine and Installation Costs	$200,000.00
Additional Capital Investment	$50,000.00
Total Initial Investment	$250,000.00

Total Initial Investment is $250,000

b) Step 2: Calculation of Total Cash Flows from years 1 to 5

Cash Inflow	1	2	3	4	5
Operating Revenue	$60,000.00	$66,000.00	$72,600.00	$79,860.00	$87,846.00
Salvage Value of Machine					$20,000.00
Total Cash Inflows	$60,000.00	$66,000.00	$72,600.00	$79,860.00	$107,846.00

Note : The operating revenues are increasing @10% every year.

Example Year 2 Operating Revenue = $60,000*110% = $66,000

c) Step 3: Calculation of NPV

NPV = Present value of cash outflows - present value of cash inflows

Particulars	0	1	2	3	4	5
Cash Outflows
Total Initial Investment	$(250,000.00)
Cash Inflows
Operating Revenue & salvage Value		$60,000.00	$66,000.00	$72,600.00	$79,860.00	$107,846.00
Net Cash Flows	$(250,000.00)	$60,000.00	$66,000.00	$72,600.00	$79,860.00	$107,846.00
PVF @12%	1.000000	0.892857	0.797194	0.711780	0.635518	0.567427
Present Value of Cash Flows	$(250,000.00)	$53,571.43	$52,614.80	$51,675.25	$50,752.47	$61,194.72

Note: Discount rate = 12 %

NPV = $19,808.66

c) Step 4 : Calculation of IRR

IRR is the rate at which NPV = 0, Since NPV @12% is positive, therefore we will discount the cash flows at a higher rate

Let Discount rate be 15%

Particulars	0	1	2	3	4	5
Net Cash Flows	($250,000.00)	$60,000.00	$66,000.00	$72,600.00	$79,860.00	$107,846.00
PVF @15%	1	0.869565	0.756144	0.657516	0.571753	0.497177
Present Value of Cash Flows	$(250,000.00)	$52,173.91	$49,905.48	$47,735.68	$45,660.21	$53,618.52

NPV = $ (906.19)

Using step 3 & 4 By Interpolation

IRR = 12% + (15-12)%* 19,808.66 / (19,808.66-(-906.19))

IRR = 12% + 3% * 0.95628

IRR = 14.87% (approx)

d) Decision:

Since NPV is positive 19,908.66, it means that present value of cash inflow is higher than the present value of cash outflow.

Also, IRR 14.87% is higher than the minimum Required rate of return of project 12%.

so, considering both NPV and IRR , the investment is a good investment and should be pursued