10.4 The staff of Jefferson Medical Services has estimated the following net cas

Question

10.4 The staff of Jefferson Medical Services has estimated the following net cash flows for food services operation that it may open in its outpatient clinic.

Year                                       Expected net cash flow

0                                         ($100,000)

1                          30,000

2                  30,000

3                30,000

4               30,000

5              30,000

5 (salvage value)      20,000

The year 0 cash flow is the net investment outlay, while the final amount is the terminal cash flow. ( the clinic is expected to move to a new building in 5 years). All other flows represent net operating cash flows. Jefferson’s corporate cost of capital is 10%.

What is the project’s IRR?

Assuming the project has average risk, what is its NPV?

Now, assume that the operating cash flows in years 1 through 5 could be as low as $20,000 or as high as $40,000. Futhermore, the salvage value cash flow at the end of year 5 could be as low as $0 or as high as $30,000. What are the worst and best case IRRs? The worst case and best case NPVs?

Explanation / Answer

Answer:

NPV of the project =

2. IRR of the project is the rate at which the NPV = 0, The rate can be found using trail and error method, by discouting the project cashflow at different discount rates. (Use excel for best and quick result). We found that at a disount rate of 19%, the project IRR is close "0". The discount rate can be obtained by dividing the immediate preceeding year discount rate by (1+discount rate used).

So the project IRR is 19%.

3. The worst case & best case NPV are:

Worst case IRR & best case IRR:

At worst case, no discounting results in close to zero NPV.

So IRR in worst case is NIL.

At Best case, the discount factor of 32.5% results in ZERO NPV.

So the best case NPV = 32.5%

Year Cashflows(in$) Discount factor @10% Discounted cashflow-In$ 0 -100000 1.0000 -100000 1 30000 0.9091 27272.73 2 30000 0.8264 24793.39 3 30000 0.7513 22539.44 4 30000 0.6830 20490.40 5 50000 0.6209 31046.07 NPV = 26142.03

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