Risk and NPV J. Morgan of SparkPlug Inc. has been approached to take over a production facility from B.R. Machine Company. The acquisition will cost $1,500,000, and the after-tax net cash inflow will be $275,000 per year for 12 years.
SparkPlug currently uses 12 percent for its after-tax cost of capital. Tom Morgan, production manager, is very much in favor of the investment. He argues that the total after-tax net cash inflow is more than the cost of the investment, even if the demand for the product is somewhat uncertain. “The project will pay for itself even if the demand is only half the projected level.” Cindy Morgan (corporate controller) believes that the cost of capital should be 15 percent because of the declining demand for SparkPlug products.
Required
1. Should Morgan accept the project if its after-tax cost of capital is 12 percent?
2. If Cindy Morgan is correct and uses 15 percent, does that change the investment decision?
3. Use the built-in function in Excel to estimate the project’s IRR. Use the Goal Seek function in Excel to calculate the maximum amount that can be invested up front in order to generate an economic rate of return equal to the 15 percent rate of return specified by management as appropriate for the proposed investment.
4. Is adjusting the discount rate or the desired rate of return an effective way to deal with risk or uncertainty?
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