Garmen Technologies Ltd operates a small chain of speciality retail shops throug

Question

Garmen Technologies Ltd operates a small chain of speciality retail shops throughout Victoria

and Tasmania. The company markets technology-based consumer products both in its stores

and over the Internet, with sales split roughly equally between the two channels of

distribution. The company’s products range from radar-detection devices and GPS mapping

systems used in cars to home-based weather monitoring stations. The company recently began

investigating the possible acquisition of a regional warehousing facility that could be used

both to stock its retail shops and to make direct shipments to the firm’s online customers. The

warehouse facility would require an expenditure of $250,000 for a rented space in Port

Melbourne, and would provide a source of cash flow spanning the next 10 years. The

estimated cash flows are as follows:

Year Cash Flow Year Cash Flow

0 $(250,000) 6 $65,000

1 60,000 7 65,000

2 60,000 8 65,000

3 60,000 9 65,000

4 60,000 10 90,000

5 (45,000)

Then negative cash flow in year 5 reflects the cost of a planned renovation and expansion of

the facility. Finally, in year 10, Garmen estimates some recovery of its investment at the close

of the lease, and consequently a higher-than-usual cash flow. Garmen uses a 12% discount

rate in evaluating its investments.

(a) As a preliminary step in analysing the new investment, Garmen’s management has

decided to evaluate the project’s anticipated payback period. What is the project’s

expected payback period? Jim Garmen, CEO, questioned the analyst performing the

analysis about the meaning of the payback period because it seems to ignore the fact that

the project will provide cash flows over many years beyond the end of the payback

period. Specifically, he wanted to know what useful information the payback provides. If

you were the analyst, how would you respond to Mr Garmen? (5 marks)

(b) In the past, Garmen’s management has relied almost exclusively on the IRR to make its

investment choices. However in this instance, the lead financial analyst on the project

suggested there may be a problem with the IRR because the sign on the cash flows

changes three times over its life. Calculate the IRR for the project. Evaluate the NPV

profile of the project for discount rates of 0%, 20%, 50% and 100%. Does there appear to

be a problem of multiple IRRs in this range of discount rates? To demonstrate your

explanation, draw a graph of the discount rate versus the NPV using the 4 given discount

rates.

(c) Calculate the project’s NPV. What does the NPV indicate about the potential value

created by the project? Describe to Mr Garmen what NPV means, recognising that he

was trained as an engineer and has no formal business education.

Explanation / Answer

Solution:

Solution a) Payback period gives the indication about the projects cash flow without discounting as in when the total initila investment will be regain using the future cash flow hence in the given problem the year in which the total amount can be re gained will be

= -25000 + 60000*4 - 45000 + 65000

= 10000 positive hence in the year 6 the total initital investment would be paid back hence the answer is at the end of 6th year is the payback period

Solution b)

IRR is the internal rate of return at which the net present value becomes zero

hence the IRR is :

Hence at 16.35% the NPV becomes zero hence the IRR is 16.35%

NPV of project at different rate is :

at 0 the npv = -250000

at 20% npv :

at 50% NPV is :

at 100% the NPV will be :

solution c)

Npv is the net present value and it indicates whether the project should be selected or not because it gives the net present value of the cash flows generated from the project in the future and hence if the net present value is postive then the project should be selected otherwise the project should not be selected . Hence below 16.35% the project should be accepted

thank you.

Year Cash flow Formula discount 16.35% Present value 0 -$250,000 1 1 -$250,000 1 $60,000 1/1.1635^1 0.8591065292 $51,546 2 $60,000 1/1.1635^2 0.7380640285 $44,284 3 $60,000 1/1.1635^3 0.6340756259 $38,045 4 $60,000 1/1.1635^4 0.5447385102 $32,684 5 -$45,000 1/1.1635^5 0.4679884108 -$21,059 6 65000 1/1.1635^6 0.4020518993 $26,133 7 65000 1/1.1635^7 0.3454054118 $22,451 8 65000 1/1.1635^8 0.2967400445 $19,288 9 65000 1/1.1635^9 0.2549313097 $16,571 10 90000 1/1.1635^10 0.2190131527 $19,711 Net present value -$346

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