Question

Sonogram equipment purchase being considered Cost S450,000.00 Shipping $100,000.00 Total cost (Co Flow) Life 4-Year Residual Value $50,000.00 Price $ 100/case $100.00 Labor Fixed Cost/year S 150,000.00 Supplies $50.00 Expected inflation 10% Corporate Discount Rate Year 1 Cases number of cases (Volume) 15% 6000.00 1 Page

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Answer 1

Discount rate for project = corporate discount rate + Inflation = 15%+10% = 25%

1.a) NPV Formula:

,
where NPV = Net present value
CF = cash flows
r = required rate of return= 25%
n = time period = 1,2,3,4

NPV = CF/(1+r)"

Time	0	1	2	3	4
Cost	-450000
Shipping	-100000
Sales		600000	600000	600000	600000
Supplies cost		-250000	-250000	-250000	-250000
Labour fixed cost		-150000	-150000	-150000	-150000
Residual Value					50000
Total Cash flows	-550000	200000	200000	200000	250000
NPV @25%	-57200.00

1.b) Payback period by interpolation:

	0	1	2	3	4
Total Cash flows	-550000	200000	200000	200000	250000
Fraction of Initial cash outflow		0.36363636	0.36363636	0.36363636	0.45454545
Cumulative Fraction		0.36363636	0.72727273	1.09090909	1.54545455
Payback period = 2 + (1-0.7272)/(1.0909-0.7272)	2.750068738

1)c) Profitability Index = Present value of future cash flows / initial investment = -57200/-550000 = 0.104

1)d) Reject the proposal. The NPV is negative and the Profitability index is less than 1. This indicates that it is a loss making project and will erode firm value.