A large project requires an investment of $200 millions. The construction will t

Question

A large project requires an investment of $200 millions. The construction will take 3 years. $30 million will be spent during the first year, $100 million during the second year and $70 million during the third year of construction. Two project operation periods are being considered: 10 years with the expected net profit of $40 million per year and 20 years with the expected net profit of $32.5 million per year. For simplicity of calculations it is assumed that all cash flows occur at end of year. Compute for each alternative: The payback periods. (6 points) The total equivalent investment cost at the end of the construction .period if the company minimum required return on investment is 15%.

Explanation / Answer

(a) consider the given table for pay back period of first alternative: Assuming that net profit incurr after completion of construction that is from 4th year to 10 years.

As we can see that cumulative cash flow gets zero inyear 9 hence pay back period is 9 years.

Now consider the given table for pay back period of second alternative: Assuming that net profit incurr after completion of construction that is from 4th year to 20 years.

Pay back period = 9 year + 5/32.5 = 9 year + 0.15 = 9.015 years.

b) Total equivalent cost of first alternative:

Year Cash Flow (in million dollars) Cumulative cash flow (in million dollars) 1 -30 -30 2 -100 -130 3 -70 -200 4 40 -160 5 40 -120 6 40 -80 7 40 -40 8 40 0 9 40 40 10 40 80 11 40 120 12 40 160 13 40 200

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