You are the financial manager of a firm that is contemplating investing in a new

Question

You are the financial manager of a firm that is contemplating investing in a new project that you expect will generate cash flows of $10,000 per year for five years and then $15,000 per year for another two years. At the end of seven years you expect to sell the project's assets for $50,000. You believe that you should earn at least 14% to compensate the shareholders for the project's risk.

Step 2: Answer the questions.
Answer the following questions:

Explain the process for evaluating this project.

What is the present value of the project's terminal value?

What is the most that you should pay for this project?

Is this project consistent with the firm's goal assuming you can invest $25,000 in this project?

What is the primary goal of the firm?

Explanation / Answer

1. Present Value of cash inflows = 10000 x Cumulative PVF @ 14% for 5 years + 15000 x Cumulative PVF @ 14% for 6th and 7th year + 50000 x PVF @ 14% for 7th year

= (10000 x 3.433) + (15000 x 0.855) + (50000 x 0.399)

= $67105

If the investment in the project is equal to or lower than the above value, then project is worth accepting. In this manner, the project can be evaluated.

2. Present Value of project's terminal value = 50000 x PVF @ 14% for 7th year = 50000 x 0.399 = $19950

3. The amount to be paid at the most = Present value of cash inflows = $67105

4. In this case the amount of investment is $25000 which is lower than the present value of cash inflows. Therefore, the primary goal of the firm to maximize NPV is achieved.

Resultant NPV = Present value of cash inflows - Initial investment = 67105 - 25000 = $42105

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