Questions
1. An investment project provides cash inflows of $795 per year for eight years. a) What is the project payback period if the initial cost is $3,500? b) What if the initial cost is $5,000? c) What if it is $6,500?
2. Your firm wants to choose between two project options:
- Project A offers the following opportunity: $450,000 invested today will yield an expected income stream of $145,000 per year for five years, starting in Year 1.
- Project B requires an initial investment of $400,000, but its expected revenue stream is: Year 1 = 0, Year 2 = $50,000, Year 3 = $200,000, Year 4 = $300,000, and Year 5 = $200,000.
Assume that a required rate of return for your company is 12% and that inflation is expected to remain steady at 5% for the life of the project. Which is the better investment? Why?
3. Your vice president informs you that she has researched the possibility of automating your organization’s order-entry system. She has projected that the new system will reduce labor costs by $25,000 each year over the next five years. The purchase price (including installation and testing) of the new system is $100,000. The system is expected to have a useful life of five years, after which time it can be sold in the secondary computer systems market for $15,000.What is the net present value of this investment if the discount rate is 8.5% per year?
4. You are considering an investment in a startup that will cost $100,000 but you will receive a cash inflow of $25,000 every year for 5 years from the sale of products the startup will manufacture. The required return is 9%, and payback cutoff is 5 years. a) What is the payback period? b) What is the discounted payback period? (assume 5% discount rate) c) What is the NPV? d) What is the IRR? e) Should we accept the project?
5. Your company is planning to introduce a new online shopping service. To reduce risk, senior management propose developing the service in three stages:
a) A market test for one year with a few customers at a cost of $1 million. The likelihood of success for this test is estimated to be 75%.
b) A introductory period of one year, if the market test is successful. During this test the most widely ordered products will be available through the service to a wider audience. This phase of the project is estimated to cost $2.5 million with have a 50% chance of success.
c) Full roll-out of the service at the end of the second year if the introductory period is successful. This phase is estimated to cost $15 million and is expected to start generating revenue only by the end of the third year.
There are 3 possible outcomes from the full roll out:
|
Outcome |
Probability |
Year 4 Revenue |
Year 5 Revenue |
Year 6 Revenue |
Year 7 Revenue |
|
Huge Success |
25% |
$12M |
$15M |
$18M |
$21M |
|
Moderate Success |
50% |
$7M |
$9M |
$11M |
$13M |
|
Failure |
25% |
-$3M |
-$4M |
-$5M |
-$6M |
i) Construct a decision tree and list all the outcomes and cumulative probabilities (it may be easier to construct the tree in a different program and copy and paste into Excel)
ii) Assume all the values are present values. Should the company pursue this project based on the expected NPV?
Grading Rubric
What: An Excel (or similar) file with solutions to the five questions above posted in your Assignments Folder.