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3530 F2010- Assignment #2 - Solutions-Revised Dec 3
Question 1 - NPV
(20 marks)
Ashley Company is considering a project that requires an investment of $12,000 today.
It estimates that expected future after-tax cash inflows will be $5,000 in years 1 & 2 and
$8,000 in year 3.
The companies required rate of return on similar projects is 15%.
Based on the above, please answer the following questions.
(a) Would you accept this project if you used NPV as your decision criteria? (4 marks)
Solution
NPV = PV of cash inflows – PV of cash outflows
NPV = ($5,000 / 1.15) + ($5,000 / 1.15
2)
+ ($8,000 / 1.15
3
) - $12,000 =
$1,388.67
Given that the NPV is positive we would accept the project.
(b) Would you accept this project if you used IRR as your decision criteria? (4 marks)
Solution
IRR is the rate of return on the investment such that the NPV of the project equals zero.
NPV = PV of cash inflows – PV of cash outflows = 0
The mathematical formula to solve for the IRR can be set up as follows.
($5,000 / IRR) + ($5,000 / IRR
2)
+ ($8,000 / IRR
3
) - $12,000 = 0
Based on the above you could use trial and error to and substitute values to solve for
IRR, but this is a very tedious exercise.
Without calculating an exact figures your
conclusion would be that the IRR lies somewhere between 21% and 22%.
An easier approach would be to use your financial calculator and input the relevant
variables.
PV = -$12,000, C1 = 5,000, C2 = $5,000 C3 = $8,000 and solve for
IRR =
21.31%.
Given that the IRR is greater than the required rate of return of 15% we would accept the
project.
(c) Would you accept this project if the company requires a payback period of 2 years for
all projects.
Also calculate the payback period of this project. (4 marks)
Solution
Cash Flow
Cumulative Cash Flow
Year 0
-$12,000
-$12,000
Year 1
$5,000
-$12,000 + $5,000 = -$7,000
Year 2
$5,000
-$7,000 + $5,000 = - $2,000
Year 3
$8,000
-$2,000 + $8,000 =
$6,000
Based on the above we note that the initial investment is recovered between the 2
nd
year
and the 3
rd
year therefore we would reject the project.