Question

Northwest Records is considering the purchase of Seattle Sound, Inc., a small company that promotes and manages blues rock bands. The terms of the agreement require that Northwest pay the current owners of Seattle Sound $600,000 to purchase the company. Northwest executives estimate that the investment will generate annual net cash flows of $250,000. They do not feel, however, that current demand for music will extend beyond four years. Therefore, they plan to liquidate the entire investment in Seattle Sound at its projected book value of $40,000 at the end of the fourth year. Due to the high risk associated with this venture, Northwest requires a minimum rate of return of 20 percent.

600,000 Cost of Investment

250,000 Annual Net Cash Flows for 4 years

40,000 Salvage Value (Sold at end of 4 years)

20% Required Rate of Return

2.589 20%, 4 year factor of an annuity

0.482 20%, 4 year factor of a $1

a. Compute the payback period for Northwest’s proposed investment in Seattle Sound.

a. 2.40 years = Payback

b. Compute the net present value of the Seattle Sound proposal, using the tables in Exhibits 26–3 and 26–4.

b. 647,250 PV of Cash Flows

19,280 PV of Sales Proceeds

666,530 Total PV of future Cash Flows

(600,000) Cost of Investment

66,530 Net Present Value

c. What nonfinancial factors would you recommend that Northwest executives take into consideration regarding this proposal?

Answer 1

Solution a:

Computation of cumulative cash flows
Year	Cash Flows	Cumulative cash flows
1	$250,000.00	$250,000.00
2	$250,000.00	$500,000.00
3	$250,000.00	$750,000.00
4	$290,000.00	$1,040,000.00

Payback period = 2 years + ($100,000)/$250,000 = 2.40 years

Solution b:

Computation of NPV - Seattle Sound Proposal
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Cost of Investment	$600,000.00	0	1	$600,000.00
Present Value of Cash Outflows (A)				$600,000.00
Cash Inflows:
Annual cash inflows	$250,000.00	1-4	2.589	$647,250.00
Salvage Value	$40,000.00	4	0.482	$19,280.00
Present Value of Cash Inflows (B)				$666,530.00
Net Present Value (B-A)				$66,530.00

Solution c:

There are various non financial factor that would be considered by northwest executives regarding this proposal like experience of musicians, quality of bands, voice of musicians, life of band, need to meet competiton , legal requirement/government regulations, Availability of qualified managerial personnel etc. These factors must be considered before accepting the proposal.