Garmen Technologies Ltd operates a small chain of speciality retail shops throug
ID: 2726312 • Letter: G
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. (b) 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) (c) 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. (7 marks) (d) 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. (6 marks)
Explanation / Answer
b) Payback period is the time required to recover all the cash outflows of a project by the cash inflows generated by it.
Amount recovered till Year 5 = $60,000 + $60,000 + $60,000 + $60,000 - $45,000 = $195,000
Amount to be recovered in Year 6 = $250,000 - $195,000 = $55,000
Payback Period = 5 + ($55,000/$65,000) = 5.84615 Years
So, in this case any cash flow generated after payback period will be profits from the project.
c) IRR:
0 = -$250,000 + [($60,000)/(IRR)] + [($60,000)/(IRR)2] + [($60,000)/(IRR)3] + [($60,000)/(IRR)4] + [(-$45,000)/(IRR)5] + [($65,000)/(IRR)6] + [($65,000)/(IRR)7] + [($65,000)/(IRR)8] + [($65,000)/(IRR)9] + [($90,000)/(IRR)10] = 13.98%
NPV profile with different discount rates:
With 0% discount rate, the NPV will simply be the net cash flow of the project (total cash inflows – total cash outflow). So, it will be $295,000
With 20% discount rate:
= -$250,000 + [($60,000)/(1.20)] + [($60,000)/(1.20)2] + [($60,000)/(1.20)3] + [($60,000)/(1.20)4] + [(-$45,000)/(1.20)5] + [($65,000)/(1.20)6] + [($65,000)/(1.20)7] + [($65,000)/(1.20)8] + [($65,000)/(1.20)9] + [($90,000)/(1.20)10] = -$30,601.88
With 50% discount rate:
= -$250,000 + [($60,000)/(1.50)] + [($60,000)/(1.50)2] + [($60,000)/(1.50)3] + [($60,000)/(1.50)4] + [(-$45,000)/(1.50)5] + [($65,000)/(1.50)6] + [($65,000)/(1.50)7] + [($65,000)/(1.50)8] + [($65,000)/(1.50)9] + [($90,000)/(1.50)10] = -$144,331.15
With 100% discount rate:
= -$250,000 + [($60,000)/(2)] + [($60,000)/(2)2] + [($60,000)/(2)3] + [($60,000)/(2)4] + [(-$45,000)/(2)5] + [($65,000)/(2)6] + [($65,000)/(2)7] + [($65,000)/(2)8] + [($65,000)/(2)9] + [($90,000)/(2)10]
= -$193,164.06
(Please draw the graph on your own)
d) Project’s NPV:
= -$250,000 + [($60,000)/(1.12)] + [($60,000)/(1.12)2] + [($60,000)/(1.12)3] + [($60,000)/(1.12)4] + [(-$45,000)/(1.12)5] + [($65,000)/(1.12)6] + [($65,000)/(1.12)7] + [($65,000)/(1.12)8] + [($65,000)/(1.12)9] + [($90,000)/(1.12)10] = $47,710.13
Positive value of NPV means that the project is going to add value to the firm equal to its NPV. As this project’s NPV is positive, it will create a value of $47,710.13 for the firm.
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