Project Analysis
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ABC Corp. 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.
Calculate key financial metrics for this capital budgeting project. 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).
In a memo to the CFO, discuss the metrics and make a recommendation whether to accept or reject the project.
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Solution Summary
The solution solves the Payback period, NPV and IRR of the project and makes a recommendation as to whether to accept or reject the project.
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1. Payback Period
Initial cost of investment = 1,300,000
Cash flows:
Year 1: 500,000
Year 2: 350,000
Year 3: 475,000
Year 4: 450,000
Year 5 : 300,000
Payback Period (PB) calculation give us an idea on how long it will take for a project to recover the initial investment.
If Y is the year before the full recovery of the investment I, U is the unrecovered cost at the start of last year and CFi is the CF of the year Y+1 then:
PB = Y + U/CFi
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