Q: Your new CEO has been very supportive of new projects and asked you to assess

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Q: Your new CEO has been very supportive of new projects and asked you to assess the merits of a particular 3-year project. The information you were able to collect is the following:

You were also informed that historically the projects of this particular division have been discounted with a required return of 20%.

Specifically, the CEO asked you for the following measures for this project. Assume a straight-line depreciation over the 3 years for the $900,000 assets you need to acquire for the project.

(a) The Payback Period and the Discounted Payback Period. Do those give rise to different decisions? If so, why?

(b) Internal Rate of Return

(c) NPV

(d) What is the meaning of the values you got in (b) and (c)?

After you computed the measures above, you learned that the Marketing and Sales departments put out a memo saying that there is a possibility of new entrants in the market competing directly with the product to be produced as part of this project. The memo also points out that, in the event that new companies are able to enter the market, the expected sales will be 10%, 15%, and 20% lower in years 1, 2, and 3, respectively.

(e) Update the measures computed above in (a) - (c).

(f) Given your answers to (a) - (c) and (e), how would you recommend your CEO to proceed? What other information and analysis would you like to be able to collect and run before you need to make a definitive decision?

Explanation / Answer

Solution : To evaluate with different options we need to compute the cash flow first step 1:

Step 2 :Evaluation of methods :

I have computed NPV :

IRR is one when NPV is zero hence :

Since the NPV is almost zero at 58.1% hence the IRR is 58.1% . The IRR is maximum and huge because the sales is huge compared to the capital expenditure therefore the return is huge .

Discounted payback gets at the end of 2nd year itself as shown below :

Highlighted in the above table the year1 and year 2 present value /discounted value adds up and it is more than the initial capital outlay hence the discounted payback is 2 years

Particulars(Formulas) 1 2 3 sales 1000000 1750000 2250000 variable cost 200000 300000 400000 Gross profit(sales-variable) 800000 1450000 1850000 Depreciation = 900000/3 300000 300000 300000 Fixed cost 100000 100000 100000 Profit 400000 1050000 1450000 Cash flow(Profit+depreciation) 700000 1350000 1750000

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