On Your Mark is considering purchasing new manufacturing equipment that costs $1,300,000 and is expected to improve cash flows by $500,000 in year 1, $350,000 in year 2, $475,000 in year 3, $450,000 in year 4, and $300,000 in year 5.
Key financial metrics for this capital budgeting project have been calculated and provided by the Finance department (see below). A 14% rate of return and a payback period of less than five years are required for the project. These key metrics must include (1) payback period, (2) net present value, and (3) internal rate of return. (Use 6% as the weighted average cost of capital).
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
(1,300,000) 500,000 350,000 475,000 450,000 300,000
PV 438,596 269,314 320,611 266,436 155,811
payback 800,000 450,000 (25,000) (475,000) (775,000)
I have to discuss in a memo to my CFO, the metrics and make a recommendation whether to accept or reject the project. These numbers have confused me. Please help me understand and make the best possible recommendation.
In a memo to the CFO, discuss the metrics and make a recommendation whether to accept or reject the project.
There are three key metrics that our company looks at while evaluating projects. The first and most important is NPV. As you know NPV is the difference between present value of cash inflows and present value of cash outflows. If a project has a positive NPV, then it is adding wealth to our shareholders and so we must accept the project (provided of course we have the resources to undertake the project). The project we have here has a positive NPV of $150,769. Since the NPV is positive that a large number, we should definitely pursue this opportunity. Our shareholders will be well off if we undertake this project and the company's value will increase.
The other key metric our company looks at is the payback period. Payback period is the time it will take for the ...
The solution is detailed and explains the concepts very well. The solution is very easy to understand as well. Overall, an excellent response to the question being asked. It explains several concept of Finance in a very easy language.