Hamstring Inc. is considering a project with the following cash flows: The compa

Question

Hamstring Inc. is considering a project with the following cash flows: The company is reluctant to consider projects with paybacks of more than three years. If projects pass the payback screen, they are considered further by means of the NPV and IRR methods. The firm's cost of capital is 9%. What is the project's payback period? Should the project be considered further? What is the project's NPV? Does NPV indicate acceptance on a stand-alone basis? Calculate the project's IRR by using an iterative approach. Start with the cost of capital and the NPV calculation from part (b). Does IRR indicate acceptance on a stand-alone basis? What is the project's PI? Does PI indicate acceptance on a stand-alone basis?

Explanation / Answer

Payback = Number of years full cash flow consumed to cost + B(alance cost to be recovered / Cash flow of the next year)

First 2 years cash flow covers the cost by 22000

So the paybacke period = 2 + 3000/5000 = 2.6 years.

Since it is less than 3 years, NPV is calculated below

NPV is positive and the proposal can be accepted.

If the project is discounted by 16%, the NPV will be 160.26 and if it is discounted by 17%, the NPV becomes -295.77

IRR = A + C / (C-D) * (B-A)

A = lower rate

B = higher rate

C = NPV of lower rate

D = NPV of higher rate

IRR = 16 + 160.26 / (160.26--295.77) * (17-16) = 16.35%

Profitability INdex = 1 + NPV / Original Investment

= 1 + 3802.79/25000 = 1.152

All the indications show that the project can be accepted.

Cash flow PV @ 9% PV of cash flow C0 -25000 1 -25000 C1 10000 0.917431193 9174.311927 C2 12000 0.841679993 10100.15992 C3 5000 0.77218348 3860.9174 C4 8000 0.708425211 5667.401689 3802.790935

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