Landower, Inc., is considering investing in a project that will require an initi
ID: 2774595 • Letter: L
Question
Landower, Inc., is considering investing in a project that will require an initial investment of $430,000. The project will take till the end of 6 months before returning the first, end-of-month cash flows of $7,500 which are expected to last 7½ years. At the end of the project’s life, a $10,000 cash outlay will be required to dispose of the project and reclaim the area where the project was set up. Projects of this sort of risk generally require an 11 percent rate of return compounded monthly.
a. Compute the project’s NPV. Should the project be accepted?
b. Explain why would you not want to utilize the IRR rule to evaluate this sort of project?
c. Explain why would you not want to utilize any sort of modified IRR rule to evaluate this sort of project?
Show work please
Explanation / Answer
Initial Investment = $ 430,000
Monthly cashflows starting from 6th month end = $ 7500
Total Period of cash flows = 7.5years = 7.5 * 12 = 90 months
Required rate of return = 11%
Month ROR = 11%/12 = 0.00916667
Present Value of cash flows beginning of 6th month
=$ 7500 * [1-(1/(1+0.00916667)^90)]/0.00916667
= $ 7500 * [1-(1/(1.00916667)^90)]/0.00916667
= $ 7500 * [1-(1/2.27332762612)]/ 0.00916667
= $ 7500 * (1-0.4398838)/ 0.00916667
= $ 7500 * (0.5601162/0.00916667)
= $ 7500 * 61.10356
= $ 458,276.70
Present Value of cash flows at time 0 = $ 458,276.70/1.0091667^6 = $ 458,276.70/1.05627595
= $ 433,860.77
Additional amount to be spent at the end of the project to reclaim land = $ 10,000
Period after which the outflow happens = 8 years or 8*12 = 96 months
Present Value of Additional Amount to be paid to reclaim the land = 10000/1.00916667^96
Present value of project end cash flow = 10000/2.40125487 = $ 4,164.4892 or $ 4,164.49
Net Present Value = - Initial Investment – Present Value of cash flows at time 0 – Present value of project end cash flow
NPV = - 430,000 + $ 433,860.77 - $ 4,164.49 = - $ 303.72
Since NPV is negative, the project is not acceptable.
IRR cannot be used for judging this kind of project as
Modified IRR considers assumes that the cash flows of the project are invested at firm’s cost of capital and the initial outlays are financed at firms financing cost removing points a and b above. However, the problem with point c viz., multiple values where positive cash flows are followed by negative cash flows like the case in question. Hence Modified IRR also cannot be used for assessing projects of this kind.
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