Question

Read the scenario.

You are the financial manager of a firm that is contemplating investing $25,000 in a new project that you expect will generate cash flows of $10,000 per year for five years and then $15,000 per year for another two years. At the end of seven years you expect to sell the project's assets for $50,000. You believe that you should earn at least 14% to compensate the shareholders for the project's risk.

Answer the following questions:

• Explain the process for evaluating this project.
• What is the present value of the project's terminal value?
• What is the most that you should pay for this project?
• What is the Profitability Index?
• What is the Pay Back Period?
• Is this project consistent with the firm's goal assuming you can invest $25,000 in this project?
• What is the primary goal of the firm?

Answer 1

1. we will have to calculate Present value of all cash flow, i.e. investment, income of each year and selling proceeds of project asset, of each year discounted by 14% (minimum return required for the project). if the project's present value is positive that the project is doable with given data.

2. project's terminal value = last year cash flow + selling proceeds of project's assets = $15,000 + $50,000 = $65,000

present value of project's terminal value = $65,000 / (1 + 0.14) ^ 7 = $25,976.43

3.

year	cash flow	pv
0	-25000	-25000
1	10000	8771.93	MINIMUM RATE	14%
2	10000	7694.675
3	10000	6749.715
4	10000	5920.803
5	10000	5193.687
6	15000	6833.798
7	65000	25976.43
NPV		42141.03

Most money can be paid = $42,141.03

4. profitability index = present value of future cash flow / initial investment required = $67,141 / $25,000 = 2.6856