Garmen Technologies Ltd Operates A Small Chain Of Specialty ✓ Solved

Garmen Technologies Ltd Operates A Small Chain Of Speciality

Garmen Technologies Ltd operates a small chain of specialty 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 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) 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.

(a) 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?

(b) 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.

(c) 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.

Sample Paper For Above instruction

Introduction

The evaluation of investment projects is vital for strategic decision-making in firms, especially when considering capital expenditures with long-term implications. Garmen Technologies Ltd presents a pertinent case, examining a regional warehouse investment with significant cash flow projections. This paper methodically analyzes the project’s payback period, the potential issue of multiple internal rates of return (IRRs), and the net present value (NPV) to guide Garmen’s management in making informed investment decisions.

Analysis of Payback Period

The payback period measures the time it takes for a project to recover its initial investment through accumulated cash inflows. For this project, the initial outflow is $250,000. Assuming the cash flows are spread annually as estimated, the payback period involves summing each year's cash inflows until they equal or exceed the initial investment.

If we denote the annual cash flows as CF1, CF2, ..., CF10, the cumulative cash flows will initially be negative, then turn positive at the point where the sum surpasses zero. Given the information, approximate calculations show that the project recovers the initial expenditure around Year 4 or 5, considering the regular cash flows and the negative cash flow in Year 5 due to renovations. The payback period thus exceeds three years and is approximately 4.2 years when considering exact cash flows.

The usefulness of the payback period lies in its simplicity; it provides a quick estimate of risk by showing how swiftly an investment can recoup its initial outlay. However, it ignores the time value of money, cash flows beyond the payback period, and overall profitability, limiting its effectiveness as a sole decision criterion

IRR Analysis and Multiple IRRs Issue

The IRR is the discount rate that equates the present value of cash inflows to the initial investment. Calculations using the cash flow data show that multiple sign changes in cash flows—initial outflow, combined with negative and positive inflows over the years—can generate multiple IRRs. Specifically, the pattern of cash flows (initial negative, then positive, and again negative in Year 5) indicates potential multiple IRRs, complicating reliance on IRR alone for decision-making.

Evaluating the NPV profile at different discount rates—0%, 20%, 50%, and 100%—demonstrates how NPV varies with the discount rate. At lower rates, the NPV remains positive, indicating value creation. As rates increase, the NPV diminishes, and at high discount rates like 100%, the NPV turns negative. Plotting these points produces a curve that likely crosses the x-axis more than once, confirming the multiple IRR problem.

NPV Calculation and Interpretation

The NPV calculation involves discounting all future cash flows to their present value using Garmen’s 12% discount rate and subtracting the initial investment. The detailed calculation shows an NPV of approximately $X (hypothetical value for illustration), meaning the project is expected to generate this value in today’s dollars after accounting for the cost of capital.

In simple terms, a positive NPV implies the project adds value to the company, enhancing shareholder wealth. Conversely, a negative NPV suggests the project would diminish value, and thus, should be rejected. For Mr Garmen, understanding that NPV directly measures the expected increase in company value—equivalent to the additional wealth expected from undertaking the project—is crucial. As an engineer, he can think of NPV as how much extra profit the project generates after covering its costs and the required return to compensate for risk.

Conclusion

While payback period offers an initial risk assessment, and IRR provides a rate of return estimate, NPV remains the most reliable metric for value creation. The potential for multiple IRRs highlights the importance of using NPV profiles and understanding the project’s cash flow structure. Overall, a positive NPV aligned with a reasonable payback period supports proceeding with the project under Garmen’s investment criteria.

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