Question 1: Consider The Following Potential Investment

Question 1consider The Following Potential Investment Which Has the

Consider the following potential investment, which has the same risk as the firm’s other projects:

Time Cash Flow

0 -$185,000

1 $32,000

2 $38,000

3 $38,000

4 $40,000

5 $40,000

6 $45,000

7 $46,000

a) What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 9%.

b) If the firm requires a payback period of less than 5 years, should this project be accepted? Justify your choice.

c) Based on the IRR and NPV rules, should this project be accepted? Justify your choice.

d) Which decision rule (payback, NPV, or IRR) do you think is the best for a firm to use when evaluating projects? Justify your choice.

Paper For Above instruction

The evaluation of investment projects is a fundamental aspect of corporate finance, guiding firms in selecting projects that maximize value. In this context, various capital budgeting techniques—such as payback period, internal rate of return (IRR), and net present value (NPV)—are employed to assess the financial viability of potential investments. This paper analyzes a specific investment opportunity with specified cash flows, applying these methodologies under a weighted average cost of capital (WACC) of 9%, and discusses the efficacy of each decision rule in project selection.

Calculating the Payback Period

The payback period measures the time it takes for an investment to recoup its initial outlay. Starting with an initial investment of $185,000, the cumulative cash flows over the years are calculated as follows:

Year 1: $32,000

Cumulative: $32,000

Year 2: $38,000

Cumulative: $70,000

Year 3: $38,000

Cumulative: $108,000

Year 4: $40,000

Cumulative: $148,000

Year 5: $40,000

Cumulative: $188,000

At the end of Year 4, the cumulative cash flows amount to $148,000, which is less than the initial investment. By Year 5, the cumulative reaches $188,000, surpassing the initial outlay. To determine the exact payback period, we interpolate between Year 4 and Year 5:

Remaining amount after Year 4: $185,000 - $148,000 = $37,000

Fraction of Year 5 needed: $37,000 / $40,000 = 0.925

Therefore, the payback period ≈ 4 + 0.925 = 4.925 years.

Calculating the NPV

NPV is calculated by summing the present values of future cash flows discounted at WACC (9%) and subtracting the initial investment. Using the formula \(NPV = \sum_{t=1}^n \frac{CF_t}{(1 + r)^t} - Initial\,Investment\):

| Year | Cash Flow | Discount Factor (1+0.09)^t | Present Value |

|-------|--------------|-------------------------|----------------------------------------|

| 1 | $32,000 | 0.9174 | $29,357 |

| 2 | $38,000 | 0.8417 | $31,990 |

| 3 | $38,000 | 0.7722 | $29,371 |

| 4 | $40,000 | 0.7080 | $28,320 |

| 5 | $40,000 | 0.6499 | $25,996 |

| 6 | $45,000 | 0.5963 | $26,833 |

| 7 | $46,000 | 0.5470 | $25,162 |

Summing present values:

$29,357 + $31,990 + $29,371 + $28,320 + $25,996 + $26,833 + $25,162 = $196,929

Subtracting initial investment:

NPV = $196,929 - $185,000 = $11,929

The positive NPV indicates the project creates value worth approximately $11,929.

Calculating the IRR

IRR is the discount rate that makes the NPV zero. Approximate IRR by interpolating between two discount rates where NPV changes signs or using financial calculator/software tools. Given the positive NPV at 9%, IRR is likely higher. Using trial and error or a financial calculator, the IRR is approximately 11.0%.

Decision based on payback period

Since the payback period is approximately 4.93 years, which is less than the 5-year limit, the project meets this criterion and should be accepted on this basis.

Decision based on IRR and NPV

IRR (11%) exceeds the WACC (9%), and NPV is positive. Both indicate that the project is financially sound, and acceptance is justified.

Assessing the Best Decision Rule

Among payback, NPV, and IRR, the NPV rule is generally considered the most reliable because it measures value added and accounts for the time value of money comprehensively. IRR, while useful, can sometimes give conflicting signals for mutually exclusive projects and does not directly convey value. The payback rule is simple but ignores cash flows after the payback period and the time value of money. Therefore, I advocate for using NPV as the primary decision rule, supplemented by IRR for confirmation.

In conclusion, the investment's positive NPV and IRR above the WACC support its acceptance. The payback period criterion is also satisfied. However, employing the NPV rule ensures a focus on maximizing shareholder value, making it the most appropriate decision criterion in this context.

References

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