Question

Case 5.2. Evaluating an Investment

The Bridgewater Gazebo Company is evaluating a new line of outdoor living outbuildings to add to its successful gazebo line. The expanded manufacturing facilities would cost $1.2 million, but they expect to be able to generate cash flows from this new line that would justify this cost. The current estimates from the project manager, expecting that nearby competitors, such as Yoder Buildings, will enter this line within five years, are the following:

Year                End of Year Cash Flows

1. $100,000
2. $500,000
3. $300,000
4. $300,000
5. $100,000

6 and beyond      $50,000

The discount rate that Bridgewater Gazebo uses to evaluate future cash flows is 8%. [Hint: The cash flows for Year 6 and beyond are a perpetuity.]

A. What is the present value of the cash flows on this new line?

B. Should Bridgewater Gazebo enter this line of business? Explain your recommendation. C. What would be your recommendation if Bridgewater Gazebo used 10% to discount its future cash flows?

D. What would be your recommendation if Bridgewater Gazebo used 12% to discount its future cash flows?

Answer 1

A	B	C	D	E	F	G	H	I	J	K	L
2
3		A)
4		Discount Rate	8%
5		Net Cash Flow of the project can be represented as below:
6		Year	0	1	2	3	4	5	6	…
7		Initial investment	($1,200,000)
8		Cash Inflow		$100,000	$500,000	$300,000	$300,000	$100,000	$50,000	$50,000
9		Net Cash Flow	($1,200,000)	$100,000	$500,000	$300,000	$300,000	$100,000	$50,000	$50,000
10
11		NPV calculation:
12		NPV of the project is present value of future cash flows discounted at required rate of return less the initial investment.
13		Given the following cash flow and WACC, NPV for the project can be calculated as follows:
14		Year	0	1	2	3	4	5	6	…
15		Free Cash Flow (FCF)	($1,200,000)	$100,000	$500,000	$300,000	$300,000	$100,000	$50,000	$50,000
16		Terminal Cash Flow						$625,000
17		MARR (i)	8%
18		(P/F,i,n) for each year		0.93	0.86	0.79	0.74	0.68
19		Present Value of cash flows = FCF*(P/F,i,n)		$92,593	$428,669	$238,150	$220,509	$493,423
20		Present value of cash flows	$1,473,343.45	=SUM(E19:I19)
21
22		Hence present value of cash flows is	$1,473,343.45
23
24		B)
25
26		NPV of the project	=Present Value of future cash flows - Initial investment
27			$273,343.45	=D22+D15
28
29		Hence NPV of the project is	$273,343.45
30		Since NPV is positive, therefore the project should be accepted.
31
32
33		C)
34		Using data table NPV for different discount rates can be calculated as below:
35
36				Initial investment
37			$273,343.45	($1,200,000)
38			8%	273343.4487
39		Discount Rate	10%	106983.5021
40			12%	-14757.30695
41
42		Thus NPV is positive at 10% discount rate, therefore the project should be accepted.
43
44		D)
45
46		NPV is negative at 12% discount rate, therefore the project should not be accepted at 12% discount rate.
47