4. Sweet Surrender Inc. is considering a project with the following cash flows..

Question

4. Sweet Surrender Inc. is considering a project with the following cash flows.. a. Sweet Surrender has a policy of rejecting all projects that don't pay back within three years outright, and analyzing those that do more carefully with time value based methods. Does this project warrant further consideration?.? b. Should Sweet Surrender accept the project based on its NPV if the company?s cost of capital is 7%? Is the recommendation definite or marginal?. c. What conclusion will the firm reach based on PI and an 7% cost of capital? ?s the recommendation definite or marginal?

Explanation / Answer

a. Calculation of pay back period:

As we can see from the above table, the pay back occurs between year 2 and year 3, as the cumulative cash flows becomes positive in year 3. The exact payback will be: (2200/(2200+2400) = 0.47

Thus pay back = 2 years + 0.47 = 2.47 years. As the payback occurs before 3 years, the project warrants further consideration.

b. Calculation of NPV using 7% cost of capital:

As the NPV of the project is positive, the project should be accepted. The recommendation is marginal.

c. PI analysis:

PI = (sum of PV of inflows-investment)/investment

= (10769.56-10000)/10000

= 0.077. As the PI is less than 1, the firm should reject the project. The recommendation is definite.

Year 0 1 2 3 Cash flow -10,000 3,300 4,500 4,600 Cumulative -10,000 -6,700 -2,200 2,400

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